Throughout 2021 and in this remarkable start of 2022, high-growth stocks have been having a difficult time for fear that the Fed will hike interest rates to combat inflation and this will weigh heavily on their valuations. In this contribution based on his impact paper, professor Vittorio de Pedys challenges all three pillars of this mainstream argument.
- Inflation is exploding higher and the Fed will tighten in response.
Vittorio de Pedys’s idea: do not fear this inflation, as it will abate.
No doubt the Fed is behind the curve in dealing with inflation. The M2 money supply gauge that rose 40% from 2019 to 2021, is a clear herald of price pressure. Today’s supply chain bottlenecks are not a result of a global economy unwinding, but rather a product of economic restrictions being met with a drastic shift in demand for goods versus services. Companies are dealing with this problem, as they are re-designing their supply chains and are busy building factories (see Intel, Taiwan semiconductors). The IHS Markit PMI indices in emerging markets have all improved dramatically lately, signalling improving manufacturing capacity. The velocity of money keeps dropping: companies have been spending money less quickly due to productivity-boosting technology. This secular trend will continue to pull prices lower. Finally, comparables will be easier: in the second quarter of 2022, inflation will be measured against the much higher numbers we have seen throughout 2021. Tougher comps will naturally suppress headline inflation in 2022. Market data is confirming this view: the 5x5 years forward-forward in Libor/inflation swaps, an indicator of market expectations, is saying that market dealers are expecting a 2.5%-level of inflation five years from now.
- The Fed has finally turned hawkish and will tighten monetary policy.
Vittorio de Pedys’s idea: the Fed will chicken out ASAP.
In the tightest possible scenario, Fed funds rates will target 2.5% in 2024. Hardly a terrifying number. If the Fed raises rates above the inflation peak, it risks killing the economic expansion and producing a cascade of bankruptcies, considering the record level of corporate and student debt and its poor quality, causing an economic recession. Government debt servicing’s cost can skyrocket at the expense of crowding out other, more necessary public spending. On the other hand, if the Fed decides to stay put, as it has until now, its dovish stance will fuel inflationary expectations even more. So, the choice now looks like the inflate or die trap. A strong U.S. dollar will eventually also help. The real rate is negative 5.5%, so the government can happily sit and watch its mountain of debt (at 136% of GDP) being reduced. Looking at deliveries for end-2022 of the Fed Funds Future quoted on CBOT, the market is pricing a 0.874% O/N rate one year out from today with three rate hikes. And looking at the EuroDollar Futures we get a similar message, with June 2024 implied 3-months rate trading at an uninspiring 1.37%. Chairman Jerome Powell is no Paul Volcker, so the Fed will put an hawkish mask on to buy time and will most likely chicken out as soon as it sees inflation come down in the second half of 2022.
- High-growth, tech stocks tank in a higher rate environment.
Vittorio de Pedys’s idea: 2022 will end better than 2021 because rate hikes are positive for hypergrowth stocks. It’s the “roaring tech 20s”!
High-growth technology stocks have been dropping significantly since their all-time high around March 2021. The logic is the higher the interest rate, the higher the discount rate used in valuation models like DCF and CAPM, and the lower the value of a growth stock. But, historically, higher inflation does not sink markets. Higher rates do. And much higher rates than those planned by the Fed will be necessary to torpedo growth stocks. The economy is largely in strong shape, even if most people are unhappy about it. There are fewer signs of froth around (SPACs, Reddit investors, “meme” stocks, cryptocurrencies, IPOs). For rates, the “danger” area starts at 5%. Studies show that there has basically never been a recession with rates below 4%. Goldman Sachs recently found that US stocks have outperformed inflation 100% of the time over any 19-year window. The market is telling us that in 2016-2018 the Fed hiked rates eight times and during that time, growth stocks thrived: just look at Cathie Wood’s flagship ARK Innovation ETF (ARKK), which soared 90% in the same period. It is the fear of rising rates that hurts growth stocks: the relative suffering is confined to the anticipation of higher rates. Once this actually happens, these stocks benefit, as their superior growth capacity is correctly judged more important than a small, multiple compression due to slightly higher discount rates. Wider adoption of technology is unstoppable. Hypergrowth stocks are at the core of these forces, and they will benefit from an expanding economic environment.