The anatomy of Fed tapering is different this time

In our recent equity note Interest rate sensitivity is back in town haunting technology stocks we show quantitatively how the Nasdaq 100 Index (US technology stocks) is significantly more interest rate sensitive than the S&P 500 Index and STOXX 600 Index (see chart below). This interest rate sensitivity is key to understand the underlying risk in growth and especially bubble stocks, and the risk of higher interest rates has gone away.

The Fed will have less flexibility this time

In fact the Fed has acknowledged that inflationary pressures are more rooted and broad based, and of concern for US households seeing their purchasing power declining. The Fed has three times since early 2013 tried to taper its bond purchases all with negative impact on financial assets. Every time markets hit a big enough pain point, the Fed reversed and restarted quantitative easing. This could be done because inflation expectations were low and well anchored. But fast forward and today’s inflationary outlook is very different and the Fed might not be in a position where it can go back to expanding the balance sheet. Tapering will be accelerated in the coming months and then rate hikes are coming and if the economy or financial markets are deteriorating the Fed might have to remain tight to control inflation.

As we have said many times the past couple of months investors must balance their portfolios before the tighter monetary policy cycle kicks properly into gear. Investors should reduce exposure to growth and bubble stocks, while increasing exposure to themes that can provide some cover during inflationary pressures. The themes we think will do well during inflationary periods are mega caps (Microsoft’s recent price hike shows why), semiconductors, logistics, financial trading firms (bet on volatility), cyber security (business necessity), and the commodity sector. The fact that mega caps have reached unimaginable market power and are hugely profitable is bad for the overall economy, but it is likely going act as a cushion for the equity market when interest rates start rising.

The chart below shows another important aspect of markets that we need to be aware of. The decade of the 2010s was the best decade in terms of earnings growth adjusted for inflation in the S&P 500 since WWII. It explains the multiple expansion under lower interest rates, but it also explains the rise of passive investing as the rapid earnings growth has lifted all boats. The 2010s is unlikely be repeated in the current decade and a higher inflationary outlook will likely give rise to a different investing climate in equities and active strategies might stage a big comeback.

Higher operating margin will differentiate growth stocks in 2022

We recently modeled a growth stock which had a price implied expectation of four years into the future, meaning that the market value was derived by extrapolating consensus expectations of growth and operating margin until 2025. The interesting part of this analysis is to find out which parameter gives rise to the biggest change in market value. In this case it was not revenue growth unless it went down a lot, which would only happen under a recession scenario. An upside change to operating margin expectations drives a rather large change in value; in other words, growth companies that can raise operating margin faster than expected will get rewarded. But the most sensitive parameter to the market value was the interest rate. By moving up the 10-year interest rate by 100 basis point the company’s value fell 26% because the higher interest rate impact financing costs on debt and the cost of equity.

The example above provide a glimpse into the important battleground in equities in 2022. Higher interest rates because of higher inflation combined with the fiscal drag will create an environment with higher discount rate on cash flows while likely lower overall growth. This will penalize a lot of growth and bubble stocks, these companies can only mitigate this impact by raising operating margin beyond current expectations. If they do not manage to do that, then we could see great losses in 2022 in these pockets of the equity market.