The era of easy money is coming to a close and value investing may be due for a comeback. The Federal Reserve on Wednesday announced its plan to cool off red hot inflation by curtailing monthly bond purchases by March and raising short-term interest rates as many as three times next year. The central bank has kept interest rates near zero since March 2020 to stimulate the economy amid the COVID-19 pandemic, and has purchased billions in bonds each month to ensure money continues to circulate the economy.
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Wednesday’s announcement signals a significant shift in monetary policy that will reverberate throughout the stock market. Rising interest rates in 2022 doesn’t mean investors should expect an imminent market collapse, but it should lead to a renewed emphasis on company fundamentals and value investing, according to Deutsche Bank’s Luke Templeman.
“The end of stimulus is certain to slow the money flow into equity markets. And if rising interest rates push bond yields higher, investors will have options elsewhere in bond markets and other rate-sensitive investments that have been ignored in recent years,” Templeman wrote in the company’s top themes for 2022. “As investments aside from equities become more appealing, frustrated active asset managers may finally witness the return of fundamental investing.”
What Is Value Investing?
Value investing is a strategy based on finding undervalued companies that trade at a price lower than what their underlying fundamentals would suggest. Using fundamental analysis, value investors consider the assets, liabilities, cash flow and other factors of companies to assess their intrinsic value. Value investors seek out the stocks that are deemed to be undervalued by the market.
This strategy is often pitted against growth investing, which seeks stocks with the potential to outperform the broader market. While Warren Buffet is considered the world’s preeminent value investor, growth investing has largely outpaced its counterpart over the last decade. In fact, the S&P 500 Value index has lagged behind the S&P 500 Growth index by nearly seven percentage points over the last 10 years.
So why does Deutsche Bank see value potentially rebounding in 2022? The answer may lie in the rising interest rates.
Loose Fiscal Policies Set to Tighten
Value stocks haven’t just been outpaced by growth stocks over the last decade, but by the market as a whole. While the S&P 500 Value index has a 10-year annualized return of 10.56%, the S&P 500 as whole has produced an annualized return of 14.35% in the same timespan.
Templeman points to the low interest rate environment as a prime reason for this disparity.
“The reason for the underperformance of ‘value’ is not simply explained by the outperformance of technology ‘growth’ stocks. It is also because the financial crisis catalysed the era of super-cheap money,” Templeman wrote. “A significant proportion of this poured into equity markets, much through passive funds which bought the index. As a result, all stocks began to move in similar ways regardless of the profitability of the underlying companies.”
The target federal funds rate, a range for short-term interest rates set by the Federal Reserve, has spent a large portion of the last 12 years near zero.
In December 2008, the Federal Reserve dropped interest rates to near zero and kept them there throughout the recovery from the global financial crisis. It wasn’t until December 2015 when the Federal Open Market Committee hiked the target federal funds rate above the 0% to .25% range for the first time since December 2008. During this time, the Federal Reserve also expanded its purchase of longer-term securities in an effort to bring down longer-term interest rates and increase economic activity.
While the target rate steadily rose in subsequent years and reached 2.25-2.50% in late 2018, the low-interest environment returned at the onset of the COVID-19 pandemic. The Federal Reserve slashed rates twice in March 2020 in response to the economic turmoil the pandemic unleashed, dropping the target federal funds rate back between 0% and .25%. It’s remained near zero since then.
But interest rates are poised to rise once again, as federal officials look for ways to combat historically high inflation. Consumer prices were 6.8% higher in November than they were a year earlier, the largest 12-month difference that’s been recorded since June 1982. On Wednesday, the Federal Reserve projected it could raise rates three times in 2022, followed by two rate hikes each in 2023 and 2024. The central bank also announced it would reduce its monthly bond buying twice as fast as it initially planned.
What does this all mean for investors? They may want to adopt a value-based approach, Templeman wrote.
“In 2022, as equity markets lose the flood of money that has propped up all stocks over the last decade, investors may be forced to become more discerning,” he wrote. “None of this means overall equity markets will crash. Rather, it may lead to a reordering within equity markets as we witness the return of fundamental value investing.”
Bottom Line
For years, the stock market has benefitted from an “easy” money policy adopted by the Federal Reserve in the aftermath of the global financial crisis, Deutsche Bank’s Luke Templeman wrote. But with both interest rates expected to rise and government stimulus poised to subside in 2022, Templeman said fundamental value investors may see a resurgence.
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