Q4'21: Mission Impossible
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In 1914, upon the establishment of the Federal Reserve banks, then Secretary of the Treasury, William McAdoo, proclaimed “the opening of these banks marks a new era in the history of business and finance in this country, [the Fed] will give such stability to the banking business that the extreme fluctuations in interest rates and available credits which have characterized banking in the past will be destroyed permanently” . More than a century later, we can conclude that such banking crises were not averted, but aggravated, each often more damaging and prolonged than the last.
Engaging a central planning committee to decide the price of money – what could go wrong?
Between a Rock and a Hard Place 📦
Jerome Powell is arguably the most powerful man in the world, yet many Americans likely still don’t know his name. A 2014 survey found that just 24% of Americans could correctly pick out the Fed chair at the time, Janet Yellen, from a list of four . Despite Powell's influence, he stands helpless in the face of inflation the Fed helped generate. Inflation, which rose to 7% year-over-year in December – its highest level in 40 years, is now atop the political agenda in Washington. Democrats, desperate to regain footing ahead of the midterms, are vocally calling on the Fed to tighten monetary policy in hopes of suppressing rising prices. The Powell predicament? The culprits of inflation are not immediately addressable using a monetary policy toolkit without unwanted repercussions. His tools, primarily tighter financial conditions, won't be fancied by asset markets, nor the American consumer, who is already showing signs of distress in response to rising costs of living, both fundamental to the US economy. The widely regarded University of Michigan survey, which captures sentiment towards the state of the economy, personal finances, business and buying conditions, fell to a new 10 year low in January.
To contextualize today’s dilemma we must first revisit how we got here. Inflation, mysteriously absent for several decades, is now rearing its ugly head. We previously called out two “this time is different” triggers that were likely to generate elevated and sustained inflation: fiscal stimulus and energy. Both factors, when layered on top of Covid-19 induced restrictions created the perfect storm. Direct stimulus transfers to American citizens, at a time when spending on many consumer services was all but prohibited, caused a drastic surge in demand for physical goods relative to services. In April 2021, personal consumption expenditures on goods rose 43% year over year and up 22.5% from pre-Covid levels.
This persistent surge in demand came coincided with dismantled supply chains, heavily constrained by Covid-19 related closures and bottlenecks. It doesn’t take a Ph.D. economist to know that an outward shift in the demand curve and an inward shift of the supply curve will raise prices. Yet somehow, the Fed, their elite team of economists, and the best real-time access to data money can buy have been completely caught off guard? Unless, of course, inflation has been part of the plan to help reign in our not-so-insignificant deficit problem, as we discussed here.
A quick way to cut through the noise is to watch what the Fed does rather than what it says. Amidst month after month of higher than forecasted inflation the Fed did nothing until November, outlining their well-telegraphed plan to taper asset purchases (keeping their foot on the gas, but a little less so). During January's FOMC press conference, Powell acknowledged inflation as a legitimate threat, announced asset purchases would end in March, and said rate hikes would begin “soon” thereafter followed by probable balance sheet reductions. If inflation is perceived as such a threat, why are asset purchases continuing? The answer and elephant in the room - the Fed is held captive by financial markets and America's twin deficits (fiscal and current account).
Quantitative Easing (QE) began as an emergency tool following the Great Recession, which for those unfamiliar involves the Fed printing digital dollars as reserves and exchanging them for Treasuries from the banking sector. This process increases the money supply, and in theory, is supposed to incentivize banks to increase lending by bolstering their balance sheets with excess cash thereby stimulating the economy through credit creation. However, in practice, commercial bank loans have stagnated. Instead, the creation of artificially low interest rates has driven investors further out on the risk curve in search of yield, with the expectation the Fed will be there to further ease at the first signs of trouble, colloquially known as the Fed Put. The result? Asset price inflation in everything from equities, bonds, and real estate to baseball cards, wine, and JPEGs.
QE is an emergency measure, but the Fed has been using it routinely throughout the 14 years since 2008. This is not unlike a doctor treating a patient in the emergency room, and instead of discharging the patient, opting to keep them bedridden with ample amounts of morphine despite being capable of walking out under their own power. After years of such treatment, it’s no wonder the system cannot function without its medication. There was even a marginal attempt to discharge the patient in 2018 when the Fed tried to normalize rates and decrease their balance sheet (Quantitative Tightening – QT) only to swiftly reverse course after financial plumbing issues in the reverse repo market ultimately led to a peak to trough decline in the S&P 500 of 20% in three months.
In our opinion, Powell and the Fed are attempting to engineer a "soft landing", whereby their hawkish tone helps to reset expectations and reign in inflation before they're required to execute all the tightening actions they speak of. Lots of bark, less bite. Thankfully, they have a few factors working for them with the passage of time: 1) The absence of fiscal stimulus should substantially reduce demand versus last year's comps; 2) Covid-19 will eventually be downgraded to endemic status; Omicron's more mild form factor combined with typical seasonality of coronaviruses should soon help shift demand back towards services while lifting many of the restrictions affecting supply chains; 3) An incredibly tight labor market (primarily due to "the Great Resignation") is forcing companies to adopt technologies at an accelerating pace, boosting productivity and providing a deflationary tailwind - more on that below.
Growth Yard Sale – Everything Must Go? 📉📈
The market reaction to the Fed’s policy change, or rather the Fed’s forward guidance, has been a major headwind for growth stocks. In a simple Discounted Cash Flow (DCF) model, an increase in the discount rate of future cash flows decreases the present value. A DCF for a growth company is heavily influenced by cash flows in future years, as the company is often sacrificing cash flow in the short term to fuel growth, and therefore present value calculations for growth companies are highly sensitive to changes in the discount rate relative to companies exhibiting slower companies. The discount rate is typically the weighted average cost of capital for the company, and in the low-interest rate environment we have today, access to capital is cheap. Therefore, the prospect of rising interest rates, at least in theory, weighs disproportionately on growth companies.
Rather ironic is the narrative that “value” companies are preferred in such an environment, when in fact most “value” companies come with large debt burdens, which would become more difficult to service. In fact, over 21% of companies in the Russell 3000 are considered “zombies”, meaning they don’t generate enough profit to cover their interest expense and therefore rely on ever-cheaper credit to stay alive. Many of these companies are components of so-called value ETFs, which use simple screening factors like Price-to-Earnings (P/E) and Price-to-Book (P/B), both not inclusive of debt burdens, to build their portfolios. Through such ETFs large asset managers can rotate between growth and value at a moment's notice, which often leads to indiscriminate selling (and buying), as company-specific fundamentals and dynamics are thrown out in favor of a single factor supposedly uniting groups of hundreds of companies.
We frequently see research and charts arguing the ratio of growth to value is at extremes last seen in the 2002 tech bubble. We cannot emphasize enough how different the circumstances are. At the turn of the century the internet was in its infancy, boasting seemingly limitless potential, but years away from mass adoption. Critically, the complexities of interacting with the internet protocol have since been entirely abstracted away into user-friendly software layers and access costs have effectively reached the zero bound. Advances in computing power and the declining cost per unit of compute have empowered accomplishments deemed impossible just a decade ago (perhaps the most fascinating to have crossed our desk recently - a paralyzed ALS patient was able to post messages on Twitter just by thinking them). Moore’s Law, named after Intel Co-Founder Gordon Moore’s 1965 assertion that the number of transistors per integrated circuit would double every year, has been the fundamental driver of innovation powering technological disruption.
Highlighted by the above chart, in 2005 it may have seemed entirely unfathomable that innovation could continue at the pace of Moore’s law, and yet since then the number of transistors per microprocessor has risen 129-fold. It’s this human inability to grasp exponential curves which leads us to overestimate the impact of technology in the short term and underestimate its effect over the long term; a phenomenon we seek to exploit as investors in innovation. Today, the advances in internet infrastructure, accessibility, and software layers have not only increased global internet users from 413 million in 2000 to more than 4.66 billion but empowered companies to scale increasingly quickly.
This ability to achieve global scale at an accelerated rate is what drives technology and software companies to forego profitability in the short-term and invest in gaining market share and building user bases as quickly as possible, because if they don’t a competitor will. Technology is pervasive, disrupting across industries and sectors - something Bill McDermott, CEO of ServiceNow, summed up nicely on his most recent quarterly earnings call - “digital technologies are [a] growth-stimulating deflationary force. They power new business models, accelerating productivity while reducing costs… A CEO I spoke to last week said it perfectly, ‘I have a long list of strategic priorities. Technology isn’t one of them. It runs through all of them'”.
Markets have a way of overreacting in both directions. At peak sentiments, there isn't a price the market wouldn't pay for the next hot technology stock, a phenomenon we saw just last year. Companies associated with buzzwords like electric vehicles, artificial intelligence, genomics, blockchain - all very powerful platforms that will define the next decade - garnered mind-boggling valuations. Markets also have a highly reactive immune system. Today, thinking they've seen this story before, markets have washed sentiment down the drain, primarily outside of index stocks, for fear of a tech bubble repeat. We believe the accessibility of markets to the masses (thanks technology) and the speed at which narratives now spread have condensed these psychological cycles from years to possibly months. We are certain the bid for "growth" will return, and in the meantime, as the saying goes - volatility creates opportunity.
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 Pollock, Alex. Does the Federal Reserve Know What It's Doing? 2016.
 Motel, Seth. Who's in charge of the Fed? Don't bank on public knowing the answer. Pew Research Center. Oct, 2014.
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 Forte, Peyton. The Number of Zombie Companies is Falling Despite Bites from Inflation and Covid. Bloomberg Quint. 2021.
 Our World in Data - Internet & Kemp, Simon. Digital 2021: Global Overview Report. Data Reportal. 2021
 ServiceNow Investor Relations. Q4 2021 Earnings Conference Call