01.19.2022: The prospect of tighter monetary policy this year is rippling through the stock and bond markets. Bond investors, anticipating three rate hikes this year, have sent the 10-year Treasury yield to 1.85 per cent, exceeding the highest yield seen in early 2021. The rate spike prompted nervous equity investors to hit the “sell” button: the S&P 500 Index is off about four per cent this year, with real estate and technology shares leading the selling lower. Investors fear higher prices will force the Fed to abandon the easy money policies that have benefitted equity risk takers over the last decade.
To suggest that monetary policy has been easy over the last 10 years would be like saying that it’s easy to get wet by falling into a swimming pool. Beginning in 2008, the Federal Reserve in effect slashed overnight rates to zero and, notwithstanding a two-year tightening program beginning in 2017, has in essence left them there. The Fed’s benchmark rate is even easier relative to inflation, moving in a downward directional stairstep pattern over the last 40 years. Now, the combination of miniscule overnight rates combined with the highest annual inflation rate since 1982 has left “real” overnight rates at their lowest level in modern history.
The Federal Reserve and other central banks took the additional step of buying Treasury notes and mortgages directly, also holding intermediate rates below “fair” value. The Fed’s balance sheet mushroomed from about $900 billion in 2008 to $8.7 trillion by the end of last year. Central bankers reckon that easy money policies support economic activity by promoting borrowing and, at the same time, encourage investment risk-taking by making it unattractive to hold “risk-free” cash. By most yardsticks, their measures worked.
Generous borrowing rates have helped push corporate delinquency rates to their lowest level in decades, according to Federal Reserve data. Homeowner delinquencies are at their lowest level since 2007. The US economy has expanded 2.1 per cent annually in inflation-adjusted terms for the last 10 years through Q3/21. Meanwhile, easy money emboldened equity investors too, pushing the S&P 500 362 per cent higher – 16.6 per cent annually – over the last decade.
While earnings growth and dividends played a part in blue chips’ success, valuation expansion – the willingness of future investors to pay a higher multiple for one dollar of earnings – was the major contributor to returns. Thanks to lower interest rates, valuation expansion fueled a 255 percentage- point gain, or 13.5 per cent of the S&P 500’s annualized return since 2011. That means that earnings and dividends, the market’s organic components, chipped in an annualized return of only about a 7.6 per cent in the interim. Technology shares were the biggest beneficiaries of valuation expansion: the S&P tech sector expanded a whopping 760 per cent, or 24 per cent annually, over the last 10 years. Earnings and dividends accounted for only 9.1 per cent of annually compounded growth.
Investors worry that higher rates and tighter financial conditions will lead to valuation compression, in effect undoing much of the Fed’s decade-long largesse. In the worst-case scenario, if the Fed were to attempt to extinguish runaway inflation by, in effect, reversing 10 years’ worth of monetary accommodation this year, we estimate the S&P 500 could fall 30 per cent and take us back to pre-pandemic levels. Through the lens of valuation and inflation, history suggests that our current inflation rate corresponds to a trailing PE ratio of less than 15x, about 40 per cent below current levels. We need inflation to gravitate toward two per cent to maintain current valuations. Given current trends, we think that is possible.