Consistent with the frenetic pace of modern life, a technology-inspired need to achieve instant gratification, and virtually endless amounts of free money, it is difficult for all of us as investors to have the patience to allow economic developments to play out over time. In our defense, who could blame us? Fed tightening in late 2018 led to a brutal sell-off in stocks before Christmas. Two weeks later, Chairman Powell might as well have brought chocolate and flowers to the floor of the New York Stock Exchange. At the start of the pandemic, the bear market associated with a recession that led to the loss of 20 million jobs lasted a grand total of three weeks. In the final analysis, policy prescriptions to deal with deflation in the U.S. can be more quickly applied and effective in fighting deflation than they are in fighting inflation. Given the regressive nature of inflation on the lives of working people, the Fed must stand in the pocket and fight it, regardless of its impact on asset prices. The CPI has been above 5% y/y for 14 months and above 7% for eight months. Inflation may have indeed peaked but it seems likely that more work needs to be done before talk of a Fed pivot is justified. A U-shaped recovery in risk assets may be the most we can hope for now.
Financial Conditions Are Likely To Tighten Further
With the Fed expected to make additional rate hikes and their balance sheet to continue to shrink, financial conditions, which have tightened rapidly over the last year, are likely to tighten further. The reprieve we are seeing now will likely be short lived as we continue to see elevated levels of inflation. In previous periods of tightening financial conditions, the index below moved from below 100 to above 100 before an extended period of loosening. We have yet to see that occur this tightening cycle.
Equity Performance Underwhelming When Financial Conditions Tighten
Equities overall are very underwhelming during periods of tightening financial conditions with leadership generally coming from defensive sectors. Staples, Utilities, & Health Care were the leaders on average, with Health Care being the only sector to outperform each period.
SMALL-MID (SMID) Cap Growth Relative Valuations Approaching Global Financial Crisis (GFC) Levels
Relative NTM P/E ratios for SMID cap growth names in the Russell 2500 Growth index are approaching the cheapest valuations relative to their large cap peers since the depths of the GFC. With that said, this relative valuation compression is coming off of higher levels than what was seen at the height of the dot-com bubble. The question investors now face is will this simply be a reversion to the mean or is there a possibility of overshooting to the downside akin to the overshoot to the upside seen in 2021. We’re of the view of the latter here, not the former.
Dividends In The Short Run And For The Long Run
As we’ve highlighted since the beginning of the year, we’re in favor of short duration equities and dividend payers in particular relative to their non-profitable long duration peers. Although this cohort of securities has outperformed YTD given their increased margin of safety in a broadly risk-off tape, our work has shown that companies who grow their dividends have outperformed over the long run as well. In our view, dividends will play an integral role in the return profile for stocks moving forward as we exit a regime of low inflation and loose monetary policy.