So just how significant was Federal Reserve Chairman Jerome Powell’s speech on inflation? In the speech that markets were eagerly awaiting, Powell announced the Fed would target inflation to average 2% over time, and that the central bank won’t feel obliged to raise interest rates if it believes the economy is running at full employment.
The S&P 500
on Thursday edged up to a new record, while the Nasdaq
slipped, though to its second-highest perch ever. U.S. Treasury yields rose, particularly at the long end
which isn’t the direction you would expect from an ostensibly dovish move. Perhaps, as University of Oregon professor Tim Duy wrote, the market perceived there was no “meat on the bones of this policy” because the central bank left implementation fuzzy.
But that is the short-term view. Joachim Klement, investment strategist at U.K. brokerage Liberum Capital, said the Fed’s change of policy goals makes it almost inevitable that the next five years will be dominated by a Japan-like environment of low nominal and real, or inflation-adjusted, interest rates.
In a note entitled, “Low rates forever? — Possibly,” Klement points out that had the Fed abided by its new inflation strategy, it would have left interest rates unchanged for a decade after the 2008 financial crisis. “Given the historic experience and current Fed and market implied forecasts, we find it safe to argue that the Fed will not hike interest rates not just for three years, but for the next five years if not longer,” he says.
Quantitative easing will continue because the Fed will need to keep nominal rates low across the yield curve, he says. For 10-year Treasurys
this means a level of 2% to 2.5% to keep it in the range over the last decade — which would imply a big upward move from current depressed levels “but not enough to impede the cost of borrowing.” The Bank of England and European Central Bank will also have to keep interest rates low, just to avoid having their currencies appreciate versus the dollar
though the difficult economic situation Europe and the U.K. are facing would make any tightening unlikely anyway.
He concedes, over the next 12 months, growth stocks are priced for perfection, and value may outperform. “However, low nominal and real rates mean that discount factors for future cash flows will decline and with it, stock market valuations are likely to increase. Stocks with a larger portion of cash flows further in the future (in other words growth stocks) experience a stronger rerating than high dividend stocks and stocks with less growth,” he said.
He highlighted companies with strong sales and earnings growth but low leverage, which have the space to further boost their growth through borrowing. For MarketWatch, he produced a screen of S&P 500 companies with strong sales and earnings growth but low levels of financial leverage.
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