Monetary policy is one of the underlying factors that influences the path of equity price returns. This is because monetary policy is responsible for the prevailing level of interest rates, which in turn shape investors’ required return expectations, as well as the appetite of companies to borrow and invest in their own businesses. Recall that the US Federal Reserve (Fed), the central bank of the US, has a dual mandate:
- Orderly price stability in the form of measured inflation targeted at 2%; and
- Maximum, inclusive, full employment.
An analysis of Federal Reserve Chair Jerome Powell’s remarks at Jackson Hole would indicate the progress made in each area. In terms of price stability, Mr. Powell reiterated that the current elevated inflation readings are likely to “prove temporary” and that the increases seen have mostly been focused on a narrow set of categories associated with the economic re-opening (fuel prices, hotel rooms, airfares, durable goods). On employment, he stated that the US is still short of 6 million jobs from February 2020, when the pandemic first started, and that “we have much ground to cover to reach maximum employment” with “little evidence of wage increases that might threaten excessive inflation.” Furthermore, Mr. Powell continued to reiterate the factors that have led developed markets, even in good times, to experience disinflationary growth and these factors are technology, globalization, and demographic shifts. He also cites that long-term inflation readings have moved less dramatically than current readings, showing that households and businesses expect its current effects to be transitory. In sum, what this means for investors is the Federal Reserve is likely to remain highly accommodative in the easing of financial conditions, supporting overall equity market valuations.
The second factor influencing markets is earnings growth. Past readers will know that this is the factor we primarily focus on, as over a long time frame, the compounding growth characteristics of a company’s earnings profile is the main determinant of its share value. This year, earnings growth has been the main contributor to equity market returns, and in contrast, the corresponding valuation multiples have actually compressed since the economic re-opening in November 2020. This tells us that markets are starting to reward fundamental results reported by companies, even as concerns about growth and variants linger. We view this as constructive because markets that are earnings driven tend to be more sustainable. In addition, as the markets move from early cycle to mid cycle, we would expect more companies to be rewarded for their fundamental earnings performance, which bodes well for individual security selection.
Finally, many investors may have inadvertently subscribed to the notion of efficient markets in the sense that they may be thinking “If it’s in the news, it must be in the price.” A Bank of America quantitative survey, however, shows this year that within value stocks, “positive, significant news” has outperformed “negative, significant news” by 13% and within growth stocks, that figure is 8%. The persistence of these returns shows that it takes most investors time to incorporate news into their return expectations, resulting in less efficient market pricing than previously thought. It also goes to one of our in-house principles that stocks ultimately trade on surprises. In particular, the bigger the earnings surprise, the bigger the likely reaction of the share price. Clients can be assured that we are continually monitoring the earnings surprises produced by our companies and identifying anomalies that make for compelling investable ideas.
Warmest regards,
Grace, Sam, Leslie and Jennifer