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Key Takeaways:
- COVID-19 is no longer the most significant domestic market threat as inflation and Fed policy shifts are at the forefront.
- The Stock market is not sheltered from inflation and a hawkish Fed.
- “Meme stocks,” “stay-at-home stocks,” and large-cap stocks remain most exposed to economic shifts.
- Small-Cap, Mid-Cap, and Value Stocks remain attractive segments during inflation and Fed quantitative tightening (QT).
A return to normalcy seems to rapidly approach as fully vaccinated individuals in the U.S. advances toward approximately 50% (and increasing), COVID-19 mask requirements starting to ease, and small business sentiment beginning to recover. Since March 2020, COVID-19 consistently remained the most feared macroeconomic and socioeconomic risk to markets as uncertainty loomed. Asset managers in fixed income, equities, and alternative assets positioned their portfolios towards “COVID-Winners” and away from “COVID-Losers” as explained in Deciphering a (COVID-19) Vaccine-Driven Economic Recovery: An Equity and Fixed Income Perspective. However, as mentioned in How to Weather the Risks of an Economic Recovery: Inflation, Increasing Rates, & Tapering, the most considerable risk to markets has naturally started to shift as COVID-19 uncertainty fizzles out. Inflation, monetary policy shifts, and accelerated economic recovery have emerged as the refocused market risks.
Inflation hitting a 13 year high should not come as a surprise as the economy reopens amid the Federal Reserve’s (Fed) quantitative easing (QE) program, which subsequentially pushed interest rates to historic lows while pumping a record amount of M2 supply and liquidity into the financial system. However, as many economists believe, the aggressive QE was the correct course of (immediate) action to weather the COVID-19 storm. Unfortunately, economic growth was not expected to rebound so acutely, with the Fed planning on remaining supportive until 2024. However, with record-setting vaccine research & development, mobilizations and inoculations, the economy has rebounded (historically fast). Regardless of regional or individual opinions on masks and vaccinations, the success of the vaccine rollout has uplifted the uncertainty haze and revitalized the normalcy of businesses as infection fears decrease (especially in densely populated metros). Though a return to normalcy is a social positive, the rapidity of an economic shift of this magnitude will leave damaging aftershocks (something I call “economic growing pains”). For instance, with a growing economy coupled with low-interest rates, more capital is deployable. This encourages excess money to flow into the stock market as bond yields remain unattractive.
Additionally, this dynamic is multiplied amid record-setting M2 supply, stimulus programs, and steep increases in unemployment payouts, drastically increasing the availability of excess capital in such a short amount of time. This increase in excess capital has a direct correlation with money available for investment. A great example of this dynamic is the influx of retail investors and the contemporary uninformed meme stock enthusiasts. In short, sustained low rates and QE accompanied with accommodative policy drive stock prices higher. On the other hand, though one negative byproduct of the Fed’s current accommodative policies is inflation (though not always). However, adding an additional layer of complexity, an inflationary economic boom is great for corporate profits, which is excellent for capital spending and stock fundamentals.
Then how should investors interpret inflation and the impacts on the stock market?
Though inflationary pressures will likely remain transitory, many concurrent events can attribute to rapid inflation. For example, COVID related supply chain disruptions have caused supply scarcity of goods and services, consumer’s willingness to pay higher prices (caused by supply disruptions) and employers increasing wages to either restaff or prevent COVID created job unsatisfaction have all been catalysts pushing inflation higher, illustrated by CPI MoM increases and acute increases in consumer prices. This, accompanied by reemployment potential as COVID-19 uncertainty fades, may cause the Fed to shift its monetary policy sooner than anticipated. This shift would consist of a more hawkish tone with Fed balance sheet tapering decreasing market liquidity in the assets the Fed purchased in the QE programs (agency MBS, ETFs, Treasuries, etc.). The potential for a liquidity crunch remains a manageable and potentially predictable risk looming at some point in the future as economic cycles and Fed policy reactions remain a natural fundamental occurrence. However, investors must look past the headlines and conceptualize what a hawkish Fed and less liquidity could mean for the stock market. In short, high rates and quantitative tightening (QT) may exert downward pressure on the stock prices as capital will likely flow to lower-risk assets as yields for fixed income products resurface. Additionally, a decrease in market liquidity and a slow down on money pumped into the system will likely decrease the ability of “meme stock vigilantes” entering the market and muddle the performance of large-cap growth stocks, which have been the primary beneficiary of global stimulus and the main attributor to the V-shaped recovery from March 2020 lows. However, some of the policy shift risks may be offset by socioeconomic recovery as global reopening will likely thematically benefit growth stocks collectively (muddling overall performance).
Therefore, how should investors navigate the market when it remains impossible to predict unemployment, inflation trends, central bank timing, and the market reaction consistently?
Essentially, there are two ways to adjust portfolios to remain in a good position and experience asset returns. First, though larger-cap growth stocks may have muddled performance as the dynamics between a hawkish Fed and global reopening remain unclear, small-cap and mid-cap stocks will likely outperform their large-cap counterparts as they are more exposed to U.S. growth, global reopening, and remain slightly less exposed to the “meme stock vigilantes” and market liquidity dislocations. Second, initially mentioned in “The Great Rotation”: Is it Time for Value?, value stocks may provide dollar-for-dollar attractiveness (as long-term growth projection remains muddled by higher inflation and increased resource prices) as inflation increases and so-called “stay-at-home stocks” lose street confidence. Historically, value stocks have performed well during periods of high inflation. For example, since 1970, during the eight largest consumer prices index (CPI) percent increases, the MSCI World Value Index was up seven out of the eight instances:
Source: Catalyst Capital Advisors LLC | 06/14/2021
*MSCI World Value Index represents Value Stocks
*CPI MoM represents inflation
Additionally, during the highest U.S. inflationary period (the 1970s), the MSCI Index was up approximately 167.50% from 1975 to 1983.
Source: Catalyst Capital Advisors LLC | 06/14/2021
*MSCI World Value Index represents Value Stocks
*CPI MoM represents inflation
So far, this year, our case holds as value stocks (represented by the MSCI World Value Index) has outperformed growth stocks (represented by the MSCI World Growth Index) by more than double, as seen below:
Source: Catalyst Capital Advisors LLC | 06/14/2021
*MSCI World Value Index represents Value Stocks
*MSCI World Growth Index Represents Growth Stocks
Therefore, new risks in the markets loom. Inflation and policy shifts remain in focus as a potential market mover. Though fixed income will be affected by Fed tapering, higher inflation, and higher interest rates, some stock asset classes are also at risk. “Meme stocks,” “stay-at-home-stocks”, and large-cap growth stocks remain the most at risk amidst this fast pace economic reaction. However, small-cap, mid-cap, and value stocks remain bright spots amid inflationary pressures and Fed policy shifts to preventing an overheated economy.
