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Equities: When the spigot runs dry

ROB HARRIS 14-Jul-2021

Spigot

At some level financial professionals and investors implicitly understand that “past performance does guarantee future results.” Yet that doesn’t mean history can’t teach us a lesson or two. In fact, looking back to when the Fed last attempted to turn off its liquidity spigot has implications for an equities portfolio.


Quantitative easing, or QE, is loosely defined as a monetary policy whereby the Federal Reserve (or any global central bank) buys government bonds and other financial assets as a means to inject money into the economy and boost growth. It’s a relatively new tool that the Fed has deployed to manage some of our recent challenging economic periods. The Fed has been using QE to stimulate the economy following the Global Financial Crisis back in 2008/09 and, more recently, the coronavirus pandemic. 


But where to from here? Even as the economy appears on the mend now, it’s important to consider what happened when the Federal Reserve previously attempted to remove some of the excess liquidity it provided to the market, most notably in May 2013. That’s when Federal Reserve Chairman Ben Bernanke gave his famous speech before Congress where he said: "If we see continuing significant improvement, and we have confidence that it is going to be sustained, then we could in the next few meetings take a step down in the pace of purchases." At that time the Fed was purchasing “only” $45 billion per month in Treasuries and $40 billion per month in Agency MBS.


The bond market was unequivocal in its interpretation of the Fed Chairman’s speech. From May 2013 until the end of that year, the yield on the 10-Year U.S. Treasury (the perceived risk-free interest rate) spiked from approximately 1.6% to just over 3.0%. This period of sharply rising rates was called the “taper tantrum.” And while many pundits feared that stocks would sell off in conjunction with rising rates, the equity market decline was only fleeting. In fact, from May 1, 2013, until the end of the year, the S&P 500 rose over 18% on renewed optimism that the U.S. economy was decidedly emerging from the financial crisis. 


Remember, this taper tantrum occurred when Chairman Bernanke merely hinted at the Fed’s intention to slow its asset purchases. This begs the questions: When will the next hint come from current Fed Chairman Jerome Powell, and how will equities react? 


Fast forwarding to today, many believe the Federal Reserve should already be tapering even though it has not indicated a willingness to do so. In 2013, Chairman Bernanke gave his speech with unemployment at 7.5%, inflation at 2.5%, and the S&P 500 trading at roughly 14x earnings. Today, unemployment is approximately 6%, inflation is approximately 5.0% (as of the end of May 2021), and the S&P 500 is trading at 21x earnings. Yet the Fed remains steadfast buying a whopping $80 billion a month in U.S. Treasuries and $40 billion a month in mortgage backed securities—twice as much as during the last crisis—not to mention the buying of corporate and high-yield bonds despite credit spreads hovering around record low levels. 


At some point, maybe sooner than investors expect, the Fed must turn off the liquidity spigot and begin its QE tapering. Given that we are coming from such extreme levels of stimulus, both monetary and fiscal, equities may not follow the exact same trajectory given the previous taper tantrum. In fact, we believe this will be a time for utmost selectivity in stock selection given current valuations, and there are definitive portfolio actions that just might help investors when we finally emerge from this era of QE. We expect: 


• Non-earning and high valuation companies could be challenged by an increasing cost of capital. Approximately 40% of the NASDAQ 100 trades at a valuation of over 10x price/sales. This lofty valuation is unlikely to be supported during the next taper tantrum when rates rise quickly

.• The removal of artificially depressed interest rates is likely to result in yield curve normalization and benefit financial services companies, particularly banks. Banks are cheap on a historical earnings basis, trading at roughly 30% of typical valuations on an earnings basis and roughly 40% on a tangible book value basis. 

• Companies that exhibit pricing power with the ability to offset rising input, wage, and other inflationary costs may be poised to outperform, including many names in the consumer staples, industrial and energy sectors.

• Some businesses will benefit from new infrastructure legislation, including traditional industrial/materials companies, natural resources companies and financials, to name a few. 

 

In general, we believe that traditional value stocks remain significantly discounted compared to growth. Rotating into these value-oriented strategies might be a means to offset any potential detrimental effects of a second taper tantrum, particularly if and when capital flees growth sectors.