Growth stocks performance in a rate hike cycle

After rallying significantly for the most part of 2021, growth stocks - which are know for generating revenue and profits faster than the industry average - have been through a difficult stretch recently brought on by news that the Federal Reserve is withdrawing support from the markets and the economy. In effect, Cathie Wood’s flagship ARK Innovation ETF (ARKK) – which represents a collection of the highest growth stocks in the market – is down 26.5% since the beginning of November after having soared by more than three times since the start of the pandemic.

The volatility centers on the Fed’s effort to fight inflation by moving away from the aggressive efforts to bolster growth it put in place as the pandemic ravaged the economy in 2020. Not only is the central bank already reducing its monthly bond purchases by tens of billions of dollars a month, but Chairman Jerome Powell recently indicated even more cuts are on the way. Within months, the Fed will be buying any further Treasury bonds, compared with $65 billions a month as recently as November.

That could drag bond prices down as demand slows, lifting their yields and making it more difficult for households and businesses to borrow money. Not only would that likely slow economic growth, but it also would mean less money will be flowing through financial markets, leaving less capital available to bid for stocks and other risky assets. And once the Fed has ended its bond-buying program, attention will then turn to lifting short-term interest rates.

With the correction we have seen in the markets recently, it is increasingly looking like the stock market has already factored in, at least in part, those moves. In fact, the market began to discount eventual Fed tightening once supply chain effects became clearer this past spring, and as inflation comparatives began to acclerate.

Higher rates tend to have an outsized impact on high-multiple growth companies because they eat into future cash flow projections, which is a key metric in valuing growth stocks. In fact, the higher the interest rate, the higher the discount rate used in valuation models, and thus the lower the value of a growth stock today.

In reality though, it is normally the fear of rate hikes which is bad for growth stocks, but rate hikes themselves could actually be good for growth stocks. In anticipation of rate hikes, it is normal for investors, knowing that higher rates are going to suppress growth stock valuations, to dump these type of stocks. This happened back in 2016 when in anticipation of the Fed entering a rate hike cycle, growth stocks struggled.

However, once those rate hikes materialise, investors realise that gradual 25-basis-point increases in the Fed funds target rate don’t actually impact valuations all that much. Meanwhile, the fact that the Fed is hiking rates means the economy is doing well, which should mean that growth comanies are growing their sales and earnings more quickly. On a net basis therefore, when it comes to growth stocks during rate-hike cycles, faster sales and earning growth more than offset minor valuation compression, and they end up powering higher.

Growth stocks have underperformed meaningfully in 2021 ahead of what many are expecting to be a new rate hike cycle starting in 2022. But history says that once that rate-hike cycle does get started, growth stocks will shake out of this slump and resume their upward trajectory.

Disclaimer: This article was written by Stephen Borg, Head of Private Clients at Calamatta Cuschieri. The article is issued by Calamatta Cuschieri Investment Services Ltd and is licensed to conduct investment services business under the Investments Services Act by the MFSA and is also registered as a Tied Insurance Intermediary under the Insurance Distribution Act 2018.

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