Rising inflation and taper talks make cash flows the metric to watch
Global equity and bond markets are faced with a paradox. As supply-chain disruptions, rising demand, and accommodative central banks create havoc with this one major macro-economic indicator, inflation, the immediate concern for policymakers is: when is the most appropriate time to begin to raise interest rates.
US inflation jumped to an alarming 7% from a year ago, spooking policymakers that the persistent rise will require tighter inflation-control measures than earlier forecast. While high inflation is not new in the US, it reduces the purchasing power of the savings investors built up during the pandemic.
Minutes of the US Fed’s latest FOMC meeting minutes, released in early January, offers some pointers to what lies ahead. The minutes left on the table the option of raising interest rates earlier than anticipated. While the US Fed had forecast that it would raise its benchmark rates thrice in 2022, global equity markets are bracing for what could be four or even five rate hikes that may be needed to tame runaway inflation.
Watch for the Ides of March
Some experts are of the view that the rate hikes could start as early as March about the time quantitative easing ends. That could unnerve and unsettle financial markets. Bond yields in the US are soaring. The 10-year benchmark bond yield jumped to 1.77% in December. Contrastingly, US bond yields were about 1.25% around the middle of 2021.
More pertinent for investors is the pace of reduction in the US Fed’s balance sheet. Over the past two years since the lockdowns, governments have been quick to unleash massive amounts of liquidity that has fuelled the incessant rise in equity markets and lowered bond yields.
The US Fed’s balance sheet has more than doubled, from $4.1 trillion to over $8.7 trillion, due to accommodative stance by Fed to nurture the US economy since the pandemic began. Some of that liquidity has flowed to emerging markets, boosting asset prices, and puffing up equity valuations way above average for some time now.
Faster-than-anticipated rate hikes could change the dynamics of global markets. First, some of the high-growth technology stocks could be in for a repricing if the rate hikes are persistent. Technology stocks are sensitive to rate hikes as they reduce the valuation multiple investors are likely to give them based in the discounted cash flow valuation model.
Technology stocks are valued on the basis of discounted cash-flows, which price future earnings growth. When interest rates rise, the discount rate on these expected earnings increase, thus driving the net present value of future earnings lower. Some of this could rub-off on valuations of fintech companies and start-ups with frothy valuations based on anticipated high-earnings growth.
However, even with rate hikes, while some of the valuation sheen could come off, the US Fed’s balance-sheet-tightening plan is still some time away. The Fed is expected to whittle down its balance sheet only later this year. This will, however, be closely watched, depending on whether the US Fed’s initial rate salvos manage to curb inflation or not.
Suffice it to say that the equity markets are bracing for some rough weather, although CY 2022 has been off to a great start with bellwether indices once again nearing new highs.
India in a better shape
India has come a long way from the 2013 ‘taper tantrum’ though. There is a high import cover of more than 13 months due to its swelling forex reserves of nearly $640 billion. That puts India a better balance of payments situation. Second, inflation is still very low unlike 2013 when it was near double-digit. Back then, Indian markets were relying heavily on foreign capital. And so any unwinding of trades put emerging markets at high risk.
Not this time. Domestic capital had ushered in a huge change in India, which is now redefining India’s market dynamics.
Re-focus on cash flows
For asset managers, of course, the risk of inflation is a concern. Over the last few years, start-up valuations sky-rocketed in the rush to their becoming valuable Unicorns.
If inflation starts to get out of hand, there will be a push to invest in companies that have real metrics, of performance and stronger cash-flows.
Investors will begin to focus on sectors like inflation-hedged assets as cash generation will be the important indicator in the next two three years.
When this shift in investment stance from chasing growth and valuation to cash flows and real earnings will happen is hard to tell. Nevertheless, our investments have been following this basic tenet from the beginning.