Changes to monetary policy loom large over financial markets as 2022 begins. While policy and interest rates always affect equity market returns, we think the evolving environment reinforces the strategic importance of identifying quality companies with clear advantages for tricky times.

With inflation proving to be stickier than initially anticipated, the US Federal Reserve and other central banks are shifting away from their very accommodating policy. But in Europe and Japan, central banks have yet to follow suit. Visibility for the global outlook is still low, as COVID-19 continues to cause economic disruption. How can equity investors adapt?

Why Are Rates Rising?

To frame the monetary policy challenges, we think equity investors should start by asking one important question: Why are interest rates going up?

The answer to this question should shapes fundamental analysis of companies. Once we identify what is driving monetary policy changes, we can make better decisions about stock selection and portfolio positioning.

If rates are rising in order to slow economic activity, profitability will inevitably be reduced. Historically, central banks tended to increase interest rates to curb investment and reduce hiring and effectively to put the brakes on economic growth. Initially, the tapering announcement by the Fed in the middle of last year was thought to be the beginning of a ‘normalization’ of interest rates, which the market felt comfortable with.

However, as growth continued to gather pace in the second half of 2021 and inflation began to rise, the policy objective became more of a ‘light tap’ on the brakes. Policymakers are well aware that GDP growth is fragile and want to avoid jeopardizing the economic recovery. But continuing COVID-19 bottlenecks are pushing up inflation in such a way, that its persistence is beginning to feed into inflation expectations

As a result, central banks now face a very tricky period. Investors are becoming concerned that policymakers may be forced to tighten too aggressively. This is a legitimate concern but at present, we still expect the Fed, and other central banks that are tightening policy, to raise rates in a measured fashion, which should help avoid a dramatic hit to economic activity. To be sure, the Fed has recently signaled plans for more aggressive tightening. However, we believe expectations for four US rate hikes during 2022 are being gradually incorporated into market psychology and the Fed has room for adjustments based on the evolving inflation and economic environment.

Real Rates Matter

As these changes unfold, real (inflation adjusted) rates are also important. Real rates are currently negative in the US and the UK. If that begins to change and American and British rates move towards a positive real yield, then equities will be challenged. In particular, stocks with high valuations are likely to be rerated—as reflected in the selloff of relatively expensive US technology stocks in January alongside a sharp rise of US 10-year Treasury yields.

Stagflation is another threat. In an environment of rising inflation, if rising rates inadvertently drag down economic growth, companies will face a tough hurdle to profitability. While this scenario is unlikely, in our view, we believe businesses that thrived mainly due to the “Goldilocks” years of low rates and solid growth would be especially vulnerable to stagflation.

Diverging Regional Trends Create Opportunities

As central banks around the world weigh these variables, policy responses will diverge. Even as they face similar themes, the inflation and growth equation will differ from region to region. For example, in mid-January, European Central Bank resident Christine Lagarde pledged to do whatever it takes to reduce inflation but has refrained from announcing interest rate hikes making it clear she believes that Europe is in a very different position to the United States

If European and other central banks are more reluctant to raise rates than the Fed, the US dollar may initially strengthen. This could support European exporters, who benefit from a relatively weaker euro. Yet companies relying on European consumers could struggle, as the regional growth outlook remains challenged.

Investors should also monitor sectors that are directly affected by rising rates. In the UK, for example, variable-rate mortgages are popular; rising rates would increase financing costs for homeowners and further dampen the consumption outlook for Britain’s domestic economy.

Regional differences between companies in the same industries could become more pronounced as monetary policy diverges. For several years, investors have been accustomed to a level policy playing field, with near-zero interest rates globally. Higher rates increase the discount rates used by investors to value stocks and future cash flows, which compresses equity valuations. This could create opportunities for selective managers to identify companies that look more attractive than peers because they are profitable today and are well positioned to remain so in different monetary policy environments.

Stable Businesses for Uncertain Conditions

Businesses with clear competitive advantages to support resilient earnings growth should be able to surmount the short-term challenges of monetary policy uncertainty. Pricing power—an important attribute in normal times—will be an even bigger differentiator in a year of sticky inflation and policy changes. Companies with clear technological drivers of efficiency will be well-armed to combat inflationary pressures. Balance sheets require especially close scrutiny, as companies with larger financing needs could become more susceptible to a margin squeeze.

While many equity investors remain fixated on how rising rates affect market returns, we believe it’s more important to understand the potential impact on individual companies. Shifting policy and inflation trends during 2022 must be high on any investor’s agenda. But to see through the uncertainty, look for quality businesses with stable cash flows that can cut through the cloudy environment with a much sharper earnings light.

Mark Phelps is Chief Investment Officer—Concentrated Global Growth at AllianceBernstein (AB).

Dev Chakrabarti is Portfolio Manager/Senior Research Analyst—Concentrated Global Growth at AB.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams and are subject to revision over time.

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