By Marie Ruschmeyer
Since the start of 2021, inflation has been rising steadily and lately, the word inflation has been on everybody’s lips. Inflation soared to its highest level since 1982, indeed the Consumer Price Index rose 6.8% from a year ago in November 2020. The Covid-19 pandemic created unusual economic conditions that led to imbalances and therefore to an important increase in inflation. During 2021, the Fed and Central banks kept on saying that inflation was only temporary because it was only pandemic related. Nonetheless, it seems that inflation is now here to stay. Therefore, the Fed finally announced plans to fight inflation in 2022 by starting to taper and raising the interest rates. What would a change in the fed’s policy mean for financial markets?
The factors that explain the surge in inflation
Because of the Covid-19 pandemic, governments had to impose lockdown measures that affected and disrupted the economies. Indeed, during lockdowns a lot of factories have shuttered, and workers stayed confined at home. All this brought the economy to a standstill because the global supply was destructed, production lines halted, and shipping stalled. Also, because of this, investors started panicking and dumped all sorts of risky assets including stocks which explains that S&P 500 plummeted in March 2020. However, when the economy finally started to recover, inflation showed up and is still here today. During the pandemic, people stayed at home and spent less than usual. In addition, the US government strongly supported the economy to avoid an economic collapse and therefore helped pay people’s wages. Lockdowns and stimulus checks resulted in an important increase in individuals’ savings during that time. When the confinement measures finally started easing, people started spending again. However, strong consumer demand combined with supply shortages didn’t do well and led to an important surge in inflation. At first, fed and government officials believed that inflation was only transitory because it was pandemic related. However, they are now going back on their words and recognizing that inflation is more than just a transitory phenomenon. The fed even announced new plans to fight inflation in 2022.
The fed’s response during the pandemic and its consequences
In late February, the stock market lost approximately a third of its value and the cost of borrowing for firms sharply increased. Indeed, financial markets responded dramatically to covid-19, people panicked and dumbed risky assets. The monetary and fiscal policy implemented by the Fed allowed a rebound in the stock market and a decrease in the costs of financing for firms. Indeed, the Fed used one of its traditional tool: they cut the interest rates from 1.5% to zero interest rates. Another tool that the fed used to stimulate the economy by providing liquidity to financial markets is quantitative easing, it consists in buying longer term treasuries, mortgage bank securities and commercial debt. The fed has been buying $80 billion treasury securities per month and $40billion mortgage bank securities per month which makes borrowing for people and companies cheaper The fed also expanded its by buying corporate bonds and fund bonds. Lastly, the fed implemented spending programs for banks and for small and medium-sized companies. Thanks to this supportive monetary policy, many market classes and asset classes are at all time highs. Nonetheless, this comes as a cost because inflation is now very high.
The Fed is now willing to fight inflation by putting an end to the stimulus program and by raising interest rates
It seems that the inflation isn’t transitory and won’t naturally correct itself and therefore the fed wants to stop it before it becomes unhealthy for the economy. To do so, the fed plans to gradually stop its bond buying will be accelerated, the fed also plans to raise the interest rates three times in 2022. Indeed, increasing the interest rates means that the cost of borrowing increases and that people won’t have access to cheap credit anymore. People won’t be taking out loans as they did before and there will be less spending and therefore less inflation. Furthermore, the Fed could even sell the bonds it bought.
Impact of rising interest rates on stock market – Is the rotation from growth to value stocks happening?
The beginning of 2022 showed us that some growth companies such as tech companies were underperforming and some people even expect value stocks to outperform growth stocks in the next years.
Therefore, it’s interesting to compare growth and value stocks and see how well they both perform especially in a context of rise in interest rates. Just a quick reminder of what are growth stocks and value stocks. Growth stocks are usually more expensive. Growth stocks have a large P/E ratio (price-to-earnings) which means that their stock prices are relatively high compared to their sales or profits. Nonetheless, growth investors believe that these companies and their earnings will grow really fast. Here are some examples of growth stocks (Amazon, Alphabet, Meta Platforms).
A value stock is less expensive, its price is low when you compare it to its financial performance. Value stocks are supposed to be “undervalued stocks” that have the potential to generate future earnings. In the last decade, growth stocks have been outperforming value stocks.
It’s interesting to look at the performances of growth and value stocks during 2020 and 2021. In 2020, the covid-19 pandemic created unusual economic conditions. 2020 definitely was the year of growth stocks because growth companies in the technology and media sectors were clearly advantaged by the lockdown measures that forced people to stay at home and change their consumer behavior and by the low bond yields. However, the fed plan to raise interest rates might really negatively impact tech companies and more generally growth companies that rely on long-term gains.