In the spring of 2022, the Federal Reserve (“the Fed”) embarked upon the most rapid interest rate hikes in history to combat inflation. Reports of high inflation have been persistent, and per the Fed meeting minutes, the Fed is following a policy of aggressive monetary tightening until price pressures reverse. We believe we are likely coming close to the point at which inflation pressures reverse, but below we address the question: what if rates stay higher for a prolonged period?
A review of historical large cap sector performance prior to an inflation peak shows the utilities, information technology, healthcare, consumer staples, and energy sectors have outperformed the Russell 1000 Index over the cycles while the real estate, communications services, and materials sectors have been the biggest laggards, as illustrated in the chart below. We believe the sectors that have outperformed in the last cycles could benefit from prolonged higher rates. As always, we believe stock selection plays a critical role in the investment process.
Source: Jefferies Research, as of February 21, 2022: The sector data is based on measuring the peaks in CPI since 1985 and covers Jan-86, Oct-90, Dec-96, Mar-00, Jan-01, Sept-05, July-08, Sept-11, Feb-17, and Jul-18.
We also believe that if rates stay higher for a prolonged period, we could continue to see a “style shift” favoring value stocks over growth stocks. Growth stocks, which are typically longer duration assets (i.e., their cash flows are expected to be delivered further in the future), generally benefit from low cost of capital environments, whereas value stocks, which are typically shorter duration assets (i.e., heavier cash flow weightings are expected in the near term), could benefit versus growth stocks in a higher rate environment. As shown in the chart below, growth stocks have significantly outperformed value over the past 15 years. In our view, however, there could be additional upside potential for value outperformance should higher rates persist.
Source: Bloomberg, as of October 31, 2022
Investors must also consider capital preservation and not relative sector returns and/or the growth versus value debate only. The Fed’s aggressive actions have the potential to cause a recession and additional market volatility. However, if a recession occurs, we believe it will likely be shallow, as we see few parallels between current economic conditions and, for example, the technology earnings cycle of 2000 or the housing and financial system collapse in the wake of the global financial crisis of 2008, each of which were followed by significant recessions.
The Fed, Inflation, and the Potential Path Forward
The Fed was clearly surprised by how strong recent inflation numbers were and despite the October 2022 favorable CPI (consumer price index) report, we believe the Fed is likely to be slow to react to what is now a universally expected decline in inflation by easing too quickly. We must assume the central bank will risk the consequence of sustaining both a higher Fed Funds rate and quantitative tightening even as the economy weakens. That weakness could be more severe than many expect because of the impact of the cumulative tightening that has occurred over the past eight months. On top of higher interest rates, we think the economy will likely be affected by higher lending standards by banks and the unsustainability of the double-digit growth in installment credit necessary to sustain current spending levels. Given that it is unlikely that stocks can sustainably rally without bonds, long term Treasuries and equity sectors that are less sensitive to trends in the economy may be advisable over the next several months. Healthcare, defense-aerospace, and companies with strong free cash flow able to sustain a rising dividend flow are some examples of the types of sectors and issuers that we believe may be best able to benefit from the current environment.