The Fed Put: Its wisdom and moral hazard
With stock markets clobbered on fears of rising inflation and a recession, investors are wondering if it’s the end of the Fed Put.
In a nutshell, the Fed Put is about the US Federal Reserve stepping in to mitigate stock market declines by easing policy rates, i.e., cutting interest rates.
Why would the US Fed do that?
“In theory,” said Ruben Zamora, Head of Metrobank’s Institutional Investors Coverage Division, “since the stock market is forward-looking, current market prices reflect the future state of the largest companies in that market and in turn, offers a snapshot of the future health of the overall economy. So, there is a basis for adjusting monetary policy to preempt an economic slowdown.”
With policy easing, banks can lend more, companies are encouraged to expand, and consumers are inclined to spend. All that can lead to economic growth, not to mention a more vibrant stock market.
And yet, the Fed Put unintentionally creates a moral hazard for stock market participants, too.
“It’s a moral hazard because the market is conditioned to think that, yeah, the Federal Reserve will always cut rates to support equity markets in cases of a sharp sell-off. It’s almost like having insurance. You start taking on more risk just because you know you’re covered,” said Zamora.
This creates stock market bubbles as companies become overvalued when future cash flows are discounted using lower interest rates.
Rising inflation has complicated matters, too. As the Russia-Ukraine war wreaks havoc on global food supplies and oil prices, inflation has relentlessly accelerated globally.
Most central banks all over the world have been compelled to raise rates to help slow inflation. For its part, the US Fed has said it will be more aggressive in raising rates in 2022.
Fate of the Fed Put
For Zamora, there are two ways to look at the situation.
“Is the Fed Put gone forever? Or is the US Fed just hitting the pause button on it? I think it’s more of a pause button, it’s probably not gone. The earnings or future cash flows of the largest companies in the US offer insight into future growth. If those cash flows shrink very quickly, the Fed is not going to ignore it,” said Zamora.
“We’ll likely start seeing the effects of the Fed’s aggressive rate hikes soon, so it’s possible that by the time the FOMC (Federal Open Market Committee) meets in September, there might be enough data to give them reason to maybe ease off on hitting the brakes on the US economy, and perhaps move a bit more gradually in slowing it down,” he added.
Implications for investors
With the plunging US stock market and its effects on Asian stock markets, including the Philippines, investors must carefully consider what’s priced in in terms of the potential for future earnings growth and the intrinsic value of companies, according to Zamora.
“I think right now markets are pricing in mid- to low teens earnings growth because margins are being squeezed by high inflation. Some good companies with resilient cash flows are getting cheaper, and for us, these companies are starting to look interesting, especially if our market continues to follow the overall weakness in global equities. We like these stocks because we believe long-term returns could be quite meaningful,” he said.
It’s similar for bond investors.
“We think long-term bond yields are starting to look attractive as well. You may want to consider adding long-term bonds and increase the average maturity of your investment portfolio. It’s too early to become aggressive on long-term bond positions, we do expect bond yields to continue rising driven by concerns over inflation and large domestic bond supply, but the value of a bond portfolio that’s skewed too heavily in favor of short-term bonds is at risk as the BSP continues to normalize overnight policy rates,” he said.
As with every investment decision, a careful assessment of the risks is needed.
ANTHONY O. ALCANTARA is the editor-in-chief of Wealth Insights. He has over 20 years of experience in corporate communications and has a master’s degree in technology management from the University of the Philippines. When not at work, he goes out on epic adventures with his family, practices Aikido, and sings in a church choir.