The Federal Reserve increased interest rates by a quarter of a percentage point during their March meeting and originally planned to follow a gradual increase throughout the rest of the year. That plan is looking less and less likely.
This Thursday, Fed Reserve Chair Jerome Powell said, “It is appropriate in my view to be moving a little more quickly” to raise rates to curb inflation. Powell noted a half-percentage point (50 basis points [bps]) increase will be considered at the Fed’s May meeting. Others like St. Louis Fed President James Bullard, who has been very vocal with his hawkish rhetoric, said he would not rule out a 75-bps hike.
Powell said the Fed’s ultimate goal right now is to get the U.S. economy back in supply/demand equilibrium without creating an economic recession. Powell went on, “It’s absolutely essential to restore price stability. Economies don’t work without price stability.” Many market participants have already forecasted economic growth to slow and started to prepare for a recession.
On Monday, April 18, Goldman Sachs said the chances of a recession within the next 12 months were 15% and within the next two years were 35%. The bank’s chief economist, Jan Hatzius, said that in 11 of the 14 Fed tightening cycles since World War II, a recession came within the following two years.
The last Fed Chair to deal with this level of inflation was Paul Volcker in the early 1980s. Volcker’s approach to grappling with price surging was also to raise rates quickly; he did so to a point that led to a recession. Powell called Volcker “the greatest economic public servant of the era” and when asked if he is prepared to do what it takes to get inflation under control, he responded, “I hope history will record that the answer to your question is yes.”
With yesterday’s aggressive hawkish rhetoric, the 10-year Treasury yield ended the day up 2.71% at 2.917%—the note hit 2.95% during the session, which was the highest level since 2018. We’ve talked in the past about how rising rates hurt longer-duration assets. This does not only apply to fixed income assets but equities as well.
Future cash flows are important to investors, and when one tries to assign value to those future cash flows, you have to discount the projected values back to the present day. Interest rates are a huge part of that calculation, so as the risk-free rate increases, those future cash flows become less valuable in today’s terms. Growth companies, historically speaking, tend to have smaller cash flows than value issues. Growth issues also tend to have a more debt-ridden balance sheet, which may have to be paid off at the higher interest rates.
Lipper Flows
When looking at U.S. funds that are run through Lipper’s Holdings-Based Classification (HBC) quantitative model, Lipper U.S. Large-Cap Growth funds suffered the largest weekly outflow this past week (-$2.2 billion). The only two classifications to report inflows were Lipper Large-Cap Value Funds (+$137 million) and Lipper Multi-Cap Core Funds (+$42 million).
When combining all capitalization sizes (large, multi, mid, and small) to break down the flows by style, it becomes apparent investors are reallocating away from all growth funds. Over the last fund-flows week, growth funds saw $3.2 billion walk out the door—core funds (-$1.9 billion) and value funds (-$328 million). The trend is not just shown itself in the past few months, but really since the start of the year. Year-to-date growth funds in all capitalization buckets have reported outflows—total growth outflows are $41.2 billion. These significant year-to-date outflows for growth funds are compared to inflows of $19.0 billion into core and $14.4 billion into value.
The two most popular Lipper HBC classifications since the start of the year have been Lipper Multi-Cap Core Funds (+$17.2 billion) and Lipper Large-Cap Value Funds (+$11.3 billion).
As we progress through this current tightening cycle, flows into value funds that tend to hold financial companies whose profits come from charging their services at the higher rates will more likely continue. The already highly valued growth funds may be in for a reality check.
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