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Hello. Wednesday’s Federal Reserve statement was boring. The press conference that followed seemed boring. The market’s reaction to the presser was not boring. A comment on this, and some thoughts on the meaning of value, below.
Jay Powell doesn’t know what’s going to happen
Fed Chairman Jay Powell said nothing new on Wednesday. He signaled a rise in March, as expected, and touched on some familiar principles for shrinking the Fed’s balance sheet. But there may have been something new in his tone in comments like this:
I would say – and this point of view is widely shared on the [Federal Open Market] Commission — that both parties to the mandate ask us to gradually move away from the very accommodating policies that we have put in place during the [pandemic].
Most FOMC participants agree that labor market conditions are consistent with maximum employment, in the sense of the highest level of employment consistent with price stability — and that’s my point. personal view. . .
I think there is enough room to raise interest rates without threatening the labor market.
Powell’s micro-smidgen of tonal peddling – as well as his refusal to rule out more aggressive upside – was enough to send stocks, which had rebounded earlier (rebounding to end the day almost flat), plunging. Bond yields also rebounded (labels show yield increases in basis points):
Mr Market now expects four quarter-point rate hikes by the end of the year, with an equal chance of a fifth hike (data from Bloomberg):
May be. But we think the market is reading tea leaves that haven’t been steeped yet. In his briefing, Powell repeatedly stressed that the Fed would be “nimble,” adapting its policy to the economy:
It is not possible to predict with much confidence exactly which path for our policy rate will turn out to be appropriate. So, at the moment, we have not made any decision on the way to politics, and I emphasize again that we will be humble and agile. We’re going to have to navigate the cross-currents and actually the double-sided risks now. What I will say is that we are going to be guided by the incoming data and the changing outlook.
This kind of talk from the Fed sounds trivial, so it’s easy to ignore. But taken seriously, it’s a bracing admission that the Fed has no idea what direction growth or inflation is heading. There are too many contingencies. Powell doesn’t have a better idea than anyone of when supply or demand conditions for goods versus services will normalize. Nor can it guess the virulence of the next variant of the virus.
His hesitation is wise. As critics demand the Fed hike rates to restore credibility, Powell is giving the markets a belligerent nod while keeping his powder dry. The real risk to central bank credibility is trying to chew the market before the data is available and then getting caught off guard by a rapidly changing economy.
Nervous markets want guidance from the Fed. But for now, the central bank can only offer honesty. Investors’ best recourse is to closely monitor upcoming data releases. The Fed will also be watching. (Ethan Wu)
Value rotation is about confidence, not math
You will be forgiven for not immediately seeing that this chart could represent a seismic shift in market momentum:
It shows that US value stocks have outperformed growth stocks by a solid margin – around 10% – over the past 12 months. This has hardly ever happened in the past 15 or so years, and people are wondering if the pandemic has ended the long reign of growth stocks.
As we have argued in this space with mind-numbing repetitiveness, the prevailing theory about the recent resurgence of value falls somewhere between oversimplification and outright error. The theory is that interest rates and duration are key: as rates rise, the discount rate applied to future equity cash flows increases, which disproportionately reduces the value of the shares that have a relatively high proportion of their cash flows in the future – which is the growth stocks.
But if the (nascent) spin on growth isn’t just about interest rates, what is it? Quantitative strategist Yin Luo of Wolfe Research says fundamentals, trend following, hedge fund positioning and the current stage of the economic cycle all favor value:
The outperformance of value versus growth over the past 12 months is only partly due to rising interest rates (and rising inflation). The fundamentals of value stocks have also improved significantly – they are more profitable, with stronger analyst sentiment on the sell side. Moreover, the [market] the trend in value factors has also improved (given the recent outperformance of value factors [that] is a self-fulfilling prophecy). Second, hedge funds on average became more bullish on value stocks. . . Finally, on a macroeconomic level, the value style also tends to outperform growth halfway through an economic recovery.
Historically, Luo says, value doesn’t always outpace growth when rates rise. He’s right about that, as a 30-year chart of the value-to-growth performance ratio and annual changes in interest rates shows:
There were plenty of rate jumps that did nothing for value investors. Perhaps we should then take a step back and ask ourselves what is “value” in this context?
Clifford Sosin, who manages $2 billion for CAS Investment Partners and describes himself as a “neo-value” investor, offers this summary:
The value guys look at the asset and ask, ‘how much money is it going to generate over time?’ The others look at it and say ‘how much will the next person be willing to pay it?’
The basic concept here is prediction. Value guys want to see cash flow that they can predict and – this is the important thing – they tend to be very modest about what they can predict. Patrick Kaser, head of the fundamental equity team and Brandywine Global, says modesty is exactly what some growth investors lack. They believe they can predict which companies will “disrupt” the economy in the future:
The thing behind [growth’s long period of outperformance] is the belief that there are many more troublemakers than history suggests. And there are plenty of people who have convinced themselves, against all odds, that they are good predictors of who the spoilers will be.
What’s happening now, he says, is that predictive confidence is going down:
If you step back as an investor and say, “I’m buying a business,” what a value investor is saying is, “I want to pay a reasonable price for this business, with a margin of safety. What the market said [until recently] is we’re not going to put that safety margin, and we’re going to put a high probability on parabolic success.
Ben Inker, co-head of asset allocation at GMO, also links the concept of value to the modesty of what can be predicted, and gives a psychological explanation for why rising rates encourage this modesty:
If you think about what investors have been doing, it’s all about hopes and dreams. People are looking for life-changing feedback. . . in a world where people are interested in lottery tickets, they won’t be interested in investing in value. The thing about higher interest rates is that they make you think about what kind of return you can get that doesn’t depend on making a better prediction than the next about what the future may bring.
So is the transition to value real this time around? We have had many false springs for value over the past 10 years. In keeping with the predictive modesty preached by the value investors we spoke to, all said there was simply no way to know. But Matt McLennan of First Eagle’s global value team made two helpful points.
The first is that two sectors that have long attracted value investors, banks and real assets (from Reits to gold companies), are benefiting from rising rates and rising inflation, respectively. There is therefore a link with the current pricing environment, but not via the absurd duration link. His second point is that, by historical standards, value remains very cheap relative to growth, and so the outperformance trend in value may have more room to maneuver. This painting by Ryan Grabinski of Strategas illustrates his point well:
Value stocks are often referred to as “cheap,” but they are especially cheap today.
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