Yesterday (or perhaps late in the prior day), the ECB joined the Federal Reserve in signaling a change in policy towards fiscal tightening, specifically going backwards on its prior multi-year regime of supplying low rates and plenty of liquidity to support the global economy through the pandemic (the UK central bank also raised rates yesterday).
The million dollar question in the near term is – will a rising rate environment paired with monetary tightening (suspension of open market government bond purchasing) hurt the economy but tame inflation, help the economy and tame inflation, or hurt the economy and not tame inflation. Every tends to think about the outcome with respect to what their “book” is.
One investor group, VCs and Growth investors, talk of a central bank induced recession on the horizon. Why? In part, because the companies they own are valued (or were valued one quarter ago) at rich valuations. When rates go up, valuations decline, but rich valuations decline far more than cheap valuations broadly speaking. Simplistically, if rates go up 1% and a company traded at a 1% earnings yield (100x earnings), the valuation of the company would drop by 50% if it traded at a 2% earnings yield. If rates go up by 1% and a company trades at a 20% earnings yield (5x earnings), the valuation of the company would drop by 5% if it traded at a 21% earnings yield.
Of course, there are examples across the spectrum ending with constituents that cheer rate increases and do not believe it’s possible to have a recession given how strong the consumer, unemployment, and other core data are looking.
To that end, the reality is the vast majority of constituents across the opinion spectrum don’t truly know what will happen, chiefly because the world is a complex adaptive system that constantly evolves / morphs as inputs change. It’s not a machine that has predictable outputs with the same inputs.
The best medicine for this is understand how one’s current situation is positioned for all outcomes and avoid the worst potential spots, which in this case I believe are assets that are (1) speculative beneficiaries of high liquidity or (2) highly valued or (3) very sensitive to consumer demand.