Inflation Panic And Fed’s U-Turn Causing A Violent Valuation Reset
Yesterday, we had yet another red-hot inflation number, i.e., US CPI Inflation came in at 7% y/y (in-line with estimates). With inflation hitting multi-decade highs, the murmurs of the Fed having to perform quantitative tightening, and in turn pricking an asset bubble (including, but not limited to stocks, bonds, and houses) are growing.
After experiencing a low-interest-rate environment for more than a decade, we find ourselves deeply entrenched in the “Land of Everything Bubble” – an idea we have discussed in great detail within our investing community. Now, the immutable laws of money dictate that an interest rate Armageddon would lead to a valuation reset across multiple asset classes (stocks, bonds, housing, etc.). Hence, the talk of a valuation reset in a scenario where interest rates were to shoot higher holds credibility. However, the likelihood of the 10-year Treasury yields climbing above 2.5-3% (despite elevated inflation levels [7-10%]) is minimal.
Although broader indices (specifically Nasdaq-100) remain close to their all-time highs, a look underneath shows a completely different picture. Nearly two thirds of stocks in the tech-heavy Nasdaq index are in a bear market (down more than 20% from their 52-week highs). Furthermore, ~40% of Nasdaq-100 stocks are down more than 50% from their 52-week highs. Hence, it’s fair to say that there’s a lot of blood on the streets at this moment in time, and Mr. Market seems to be pricing in an interest rate Armageddon in high-growth stocks.
Most of us (growth investors) are having a hard time watching our portfolio values decline ~30-60% from their highs. However, as we have reiterated time and time again, volatility is inherent to growth stock investing. This too shall pass, and we will come out stronger than ever at the end of it all. A couple of weeks back, I shared some commentary around my outlook for 2022 and beyond. Here’s what I said –
With inflation hitting multi-decade highs, the FED finds itself stuck between a rock and a hard place. When the COVID-19 pandemic struck in early-2020, global governments and central banks instituted loose fiscal and monetary policies, flooding the markets with unprecedented liquidity. These policies enabled a swift, V-shaped recovery in financial markets (and reinvigorated economic growth). Although aggregate demand saw a sharp recovery, the pandemic-inflicted global supply chains breakdowns are causing a demand-supply imbalance for goods and services, leading to high inflation.
The Fed has a dual mandate – maximum employment and price stability. While unemployment numbers have gone down significantly after the pandemic-induced economic recession, we’re still not at maximum employment. However, raging hot inflation is causing panic among central bankers, and they must now tighten the monetary policy to ensure price stability. I do think that most of the inflation is being driven by supply chain issues, which are showing few signs of abating due to the rise of Omicron cases across the globe. With the risk of further lockdowns increasing the probability of a recession (deflation) in 2022, the likelihood of central banks raising interest rates next year is pretty low. The bond market seems to disagree with Fed’s hawkishness as 10-year Treasury yields continue to hover below 1.5%.
Even if interest rates were to go back up to the ~2.5-3% range, we’re still looking at historically low-interest rates. In the last few months, high-multiple, unprofitable growth stocks have rolled over, and undergone a violent valuation reset. However, profitable growth stocks have continued to rally higher. With equity markets hovering around all-time highs, Mr. Market has irrationally sold off some high-quality small caps into the ground, creating generational buying opportunities for long-term investors.
Predicting macroeconomic events is a fool’s errand, and even if you are right, the market could do absolutely the opposite of what’s expected. Hence, we must control what we can control, i.e., buy great companies below their fair values and hold long-term. With deals galore in the high-growth stock universe (robust businesses trading at dirt-cheap valuations), I think this is an opportune moment for long-term investors seeking outperformance to invest aggressively in this space.
Here at BTM, we invest in rapidly-growing, small-cap companies operating at the heart of secular-growth trends because these stocks could be big winners in the future regardless of economic factors. Source: Here
I firmly believe every word written in the note above, and we simply do not need to discuss macroeconomic factors as they are irrelevant to long-term investing strategies. However, the widespread panic among growth investors is unwarranted, and we must have this discussion to avoid getting caught up in the ultra-bearish narratives (missing out on generational buying opportunities) prevalent all around us.
Today, we will look into Fed’s apparent U-turn on monetary policy. I will reason out why this stance is more posturing and less of a damaging quantitative tightening (as we have seen in the past). So let’s get started.
Is The Fed No Longer A Friend Of The Stock Market?
The Fed has a dual mandate – full employment and price stability. With the latest unemployment rate numbers coming in at ~3.9%, the economy appears to have recovered completely from the COVID-19 pandemic fueled recession. However, a stronger-than-expected recovery in aggregate demand (coupled with unprecedented supply chain issues) has brought back the dreaded inflation [40-year high inflation rates]. Naturally, the Fed is turning hawkish:
Source: Fed Chair Jerome Powell holds a news conference after the rate decision – 12/15/21
Although the Fed decided to hold interest rates at 0-0.25% in its December FOMC meeting, the probability of three rate hikes in 2022 is growing. The first-rate hike could happen as soon as March, a point at which the FED’s asset purchases are likely to be tapered off (at ~2x fast taper). In a nutshell, the Fed is likely to begin quantitative tightening in the next few months to fight off high inflation.
The historical chart for inflation and treasury yield suggests that the Fed will increase interest rates to curb inflation (and maintain price stability). Although this correlation is pretty loose, it makes sense from a theoretical standpoint. The fact is that we are experiencing multi-decade high inflation rates (~7%), and so it is only a matter of time before the Fed must increase rates.
However, it’s important to understand the factors driving this inflation episode because these factors would dictate how fast and how high the interest rates could go. Although the Fed omitted the word “transitory” from its commentary on inflation, the bulk of inflationary pressure is a result of pandemic-inflicted supply chain issues. As the pandemic eases, supply-chains would normalize given time, and subsequently, inflation would ease off too.
Since World War II, we have seen multiple episodes of inflation, and today’s inflationary episode is very similar to the 1946-48 period (pent-up demand and supply chain constraints are major factors driving inflation). If you are interested in learning more about these episodes, I would strongly recommend you to read this note.
The Fed’s expectations for inflation in 2022 stand at ~2.6% (a sharp decline from current inflation rates), which, if true, wouldn’t require the treasury yields to rise by much to match inflation rates. But what if the Fed is wrong (as it always is) and high inflation continues to persist?
Well, higher than average inflation for a longer period (with a strong economy) is exactly what the Fed and the US government could be praying for right now. Although inflation hurts the average Joe’s pocket, global governments, and central banks find themselves stuck in a vicious debt cycle (a result of several missteps over preceding decades), which leaves no room to maneuver.
As of data released in October 2021, US National Debt stood at ~$28T (after a $4.7T jump in 13 months). Frankly speaking, the government has been borrowing more money to pay back its previous debts for years now. If the interest rates were to now rise significantly, the US government could end up borrowing even more money to pay its debt obligations, and if things spiral out of hands, the situation could result in a catastrophic debt default.
As the lender of last resort, the Fed has been buying assets left, right, and center over the past two years to keep the economy afloat. If rates were to rise precipitously, the FED’s balance sheet could get imbalanced towards liabilities if we go through another event like the “Great Financial Crisis.” Yes, the Fed can print money, but you understand the complexities involved in the current state of affairs.
Raising interest rates too fast or tapering off its balance sheet (through bond sales) are actions that could quickly lead to another economic recession, something the Fed wants to avoid at all costs. The Fed Chair, Jerome Powell, has previously tried to reduce Fed’s balance sheet (back in 2018) while increasing interest rates; however, that attempt didn’t go so well (markets tanked more than ~20%), and he had to reverse course again toward easing. As of now, Chair Powell has reiterated his desire to raise rates slowly and only if the economy can take it. However, he doesn’t really have much of a choice because a rapid rise in interest rates would lead to falling off in asset prices (bonds, houses, stocks, etc.), which could, in turn, lead to another economic recession.
The government debt problem is also not just limited to the US. It’s a global issue. Hence, global central banks are also likely to remain accommodative with their monetary policies. The room to maneuver is minimal.
When we talk about a 7%-8% treasury yield, we often forget to comprehend the economic reset it would take to get there. In such a scenario, most asset prices would tank by 70%-90% (from current levels), and there would be a catastrophic recession on the scale of the “Great Depression.” Although this may sound scary, it’s an extremely unlikely event, and if something like this were to happen, the outcome would be another round of infinite QE.
In my view, the most likely outcome for the monetary policy is slow interest rate hikes in the coming years, even if it means higher inflation for longer. Even if the 10-year treasury yields were to rise up to 3%, I do not see any significant re-rating in stocks (which are much cheaper compared to bonds at this time). In the high-growth stock universe, we have been experiencing massive volatility due to an inflation scare, however, as the inflation fades off, we will likely see a quick recovery in many of them (at least the high quality ones).
With long-term interest rates staying in the 3-4% range, a reasonable P/FCF multiple for mature (bond-like) businesses (sales growth of ~5-10% per year, robust free cash flow generation) should stand at ~25-33x. Through this lens, the majority of the stocks in the Nasdaq-100 (including FAANGs) remain fairly valued. Rapidly-growing businesses (such as the ones we own at Beating The Market) deserve higher multiples, and as such, we could expect Opendoor (OPEN) or Upstart (UPST) or Affirm (AFRM) or Roku (ROKU) to trade at ~50x P/FCF in 2026 and at ~35x P/FCF in 2031. Of course, there’s some more nuance around these future multiples based on the fundamentals of individual businesses.
During times of economic uncertainty such as the ongoing inflation episode, the short-term oriented market could behave irrationally and misprice assets; e.g., Upstart is trading at ~20x forward P/FCF despite its robust growth and future sales trajectory. However, over longer periods of time, the immutable laws of money dictate asset pricing (regardless of economic factors). Hence, predicting macroeconomic events may be a fun exercise, and discussing these ideas may sound like an intellect-stimulating brainstorming session; it is an entirely futile exercise for long-term investors.
From a historical standpoint, we are set to operate in a low-interest-rate environment for several years to come. In this note, I shared my views on the monetary policy and reasoned why central banks are likely to stay accommodative in the 2020s. Through the lens of free cash flow yields, the violent valuation reset in growth stocks is grossly overdone, and we will study some examples in a follow-up note next week.
Thanks for reading. If you are a growth investor, stay strong and do not panic sell. Buy more if funds are available, and if you are out of capital, please remember doing nothing is an optimal strategy (after all, data has shown in the past that dead investors tend to outperform the living ones). Please share any thoughts, questions, or concerns in the comments section below.