On March 16th Fed Chairman Powell capitulated to raising rates aggressively throughout 2022 to conquer soaring inflation.* As we foresaw, inflation soared post Covid, as the supply shock induced recession driven by the virus did essentially nothing to diminish consumer demand.** Inflation, measured by the Producer Price Index, soared to 10% on a year-over-year basis as of the March 15th 2022 report, dramatically over the 2% target of the Federal Reserve.*** Powell’s commentary that the 25 basis point rate hike he announced on March 16th could be the first of seven this year, some even at 50 bps, is in our opinion an absolutely clear signal that the Fed will now concentrate on its core mission of price stability. Incredibly, even with this sledge-hammer approach to rate hikes for the balance of 2022, Powell indicated that inflation would still run at over their 2% through 2024.****
The Fed Signaled a Shift from Patient to Aggressive
Powell, in our view, was clear that one of his main concerns was the impact of inflation on the lower income segment of our country. We see inflation as an incredibly regressive tax, and it appears Powell agrees, as he discussed the negative impact of inflation on the consumer who is spending their entire paycheck food, housing and transportation. 10% inflation means 10% less purchasing power for this consumer. This is not an acceptable level of inflation for the Fed, and it will likely develop into a liability for the administration into the fall elections. Thus, we take the Chairman at his word that he will raise rates aggressively in 2022, and will most likely begin to reduce the Fed’s balance sheet (sell bonds) that ballooned during the Covid recession to $8.9 Trillion.*****
In our view, the implications for investors are clear, and are 100% in line with the views we have written about for over 2-years in our Market Musing blogs (Market Musings | Rewey Asset Management | Long-Term Investing). We believe the recent performance of small cap value should continue, and that:
Banks will likely prosper from higher rates.
Industrials with strong demand will be able to raise prices to overcome inflation.
Domestically focused small industrials will prosper from higher demand as the fallacy of over stretched Just-In-Time global supply chains have been shown to be stretched Just-To-Far, which should mean accelerating domestic capital investment.
The valuation levels of large cap momentum growth stocks will likely suffer due to higher interest rates (weighted average cost of capital assumptions will most likely soar with rising rates, increasing the denominator in DCF models which will likely dramatically cut the net present values of companies with weak current cash flows and valuations heavily dependent on 10-year+ terminal values).
Don’t Fight the Fed
“Don’t Fight The Fed” is an idiom that has withstood the test of time on Wall Street. We see the March 16th Fed announcement as a clear signpost of successively higher interest rates. We believe this move will accelerate the move away from overvalued momentum growth stocks, into what we see as very undervalued small/smid cap value stocks.
*Federal Reserve release 3/16/2022. Federal Reserve Board - Federal Reserve issues FOMC statement. Federal Reserve press conference 3/16/2022 Federal Reserve Board - News & Events
**See our blogs at Market Musings | Rewey Asset Management | Long-Term Investing, including will a vaccine bring inflation as well as immunity.
***10% February 2022 US PPI Final Demand YOY NSA, Bureau of Labor Statistics, via Bloomberg.
****Federal Reserve statistical summary The Fed - March 16, 2022: FOMC Projections materials, accessible version (federalreserve.gov).
*****Federal Reserve balance sheet as of 3/9/22 Federal Reserve Board - Recent balance sheet trends
Assumptions are based on current beliefs and are subject to change based on many factors including, market and other conditions. There is no guarantee that forward-looking statements will come to pass. This information should not be construed as a recommendation of any specific security or investment type. Please see additional important disclaimers https://www.reweyassetmanagement.com/website-disclaimers.
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