Fed tightening accelerates ‘growth’ to ‘value’ rotation

“There must be some kind of way out of here, Said the joker to the thief. There’s too much confusion, I can’t get no relief”

Central bankers would no doubt echo Jimi Hendrix’s howl (or Bob Dylan’s if you prefer the original version of ‘All Along the Watchtower’) as they struggle to decipher the signal from the noise and navigate the global economy away from a period of unprecedented policy stimulus. The Federal Reserve presaged a tightening of monetary policy as long ago as last September but the hawkish tone of its January meeting left investors fearing overkill and a policy error. Bonds sold off, volatility increased, and the rotation from ‘growth’ to ‘value’ accelerated.

Markets are in a state of flux. The potential for an aggressive tightening cycle has destabilised, both the risk-free rate and the equity risk premium. The impact has been felt most acutely in longer duration assets whose cashflows are back-end weighted. The sharp decline in many of these stocks highlights the non-linear relationship between valuations and interest rates when the cost of capital is exceptionally low. Despite the increase in volatility, the tightening of liquidity is appropriate at this point in the cycle. Many commentators are focused on the squeeze on real incomes due to higher inflation and the potential for a classic wage-price spiral. Perhaps we are too sanguine, but the significant improvement in household finances over the pandemic should provide substantial mitigation.

Distortions from the pandemic have been significant and investors (and central banks) need to be careful not to draw the wrong conclusions. The secular factors impacting the global economy are largely unchanged and generating sustained high inflation is a longer and more complex process than commonly assumed. Nonetheless, tighter policy is appropriate and investors will need to adjust their playbook accordingly. The economic outturn, however, may turn out to be more akin to Dylan’s more sedate original rather than the cacophony of Hendrix’s masterpiece.

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