Strategist: ‘There’s no question that rising real rates’ will hurt growth stocks

F.L. Putnam Chief Market Strategist Ellen Hazen joins Yahoo Finance Live to discuss the market reacting to the Fed's monetary policy and interest rate hikes, inflation, real rates' influence on growth stocks, barbell strategies, and earnings season forecasts.

Video Transcript

- Ellen, good to see you. Happy Monday to you. What do you see in the general market move today?

ELLEN HAZEN: Generally, the market's fairly optimistic. Certainly it liked the Tesla news that it saw. And it seems as though the market is digesting the recent cues from the Federal Reserve that, in fact, they may go 50 basis points at the next meeting and 50 for a couple more after that. The market is taking the weekend to get adjusted to that. And the market seems fairly healthy today.

- How aggressive do you expect the decision making to be from the Fed from here, even though it may not be squarely in the radar of the equity markets here today, certainly something lingering going forward?

ELLEN HAZEN: The Fed has gone to great pains to say that there will be data dependent. And I expect that they will do that. What we're watching for, and what we think the Fed is also watching for, is the degree to which inflation becomes embedded in expectations in the market. So for example, not only are we watching for what the CPI is going to do in April, but more importantly, we're looking at the jobs number this Friday and what the average hourly earnings are.

So if we don't see significant inflation in hourly earnings, then it's a real positive, because it means that wage price spiral that we saw in the 1970s is not happening yet. Of course, we'll see what happens. We should expect, though, that the CPI will remain high for at least the next few months, because it takes that long to anniversary last year's numbers. CPI didn't really start to spike until the summer last year. So we think the Fed is going to watch and wait. If they do see it be embedded, though, in wage expectations, then you can expect them to move faster.

- So Ellen, how are the trends that you're seeing in terms of rising inflation and rising rates, how is that informing your current investment strategy?

ELLEN HAZEN: Certainly as we see rising inflation and rising rates, it continues the trends that we saw from last year. And it really accelerates those. So specifically, rising rates are negative for very long duration equities. So in other words, those companies that have a lot of earnings very far out in the future, higher rates are negative for those.

And if you look through the first three months of this year, very expensive growth stocks, which really exhibit those tendencies, and those qualities have done very poorly. Through the end of February, growth had underperformed value by, I think, 900 basis points and underperformed again in March, although a little bit more modestly. So there's no question that rising real rates is going to hurt growth stocks.

At the same time with the inflation, we want to own companies that can pass through inflation. And that means a lot of either real assets, so looking at real estate, for example, but also companies that can pass through inflation, like materials.

And then finally, so much of the inflation is concentrated in the energy sector, we're really looking at that accelerating the trend toward green energy as we had seen already. Again, this has really accelerated that. So we're looking for opportunities to buy companies that are going to benefit from electric vehicles, from battery storage, et cetera.

- Ellen, is this what you mean by your barbell strategy? And how does the market dictate that strategy?

ELLEN HAZEN: Absolutely. So for our barbell strategy, what we're investing in are companies that have growth, but not so far out in the future that they're very long duration. So we're looking for companies that have high quality growth in the near to intermediate term. And then at the same time, we're looking for cheap cyclical stocks that will do fairly well in a rising rate environment.

And so we want a balance of both of those. But what we're really staying away from are the expensive growth stocks, particularly those that have no earnings or negative earnings, or very, very low earnings. And then on the bond side, we're staying away from conventional treasuries and instead looking at inflation protection on that side as well.

- What's your outlook for what we're expecting to hear this earnings go round, especially considering both international tensions, the impact on supply chain that companies are still navigating through, and the lingering COVID effects that many of them may have to price in?

ELLEN HAZEN: So companies will start reporting first quarter earnings in the middle of April. And what we're seeing now is that we actually think operating margins are going to contract on a year over year basis. So right now, consensus is looking for revenue growth of 10% for the S&P 500 for the first quarter. And that is not bad. 10% revenue growth is not bad at all.

But earnings are only expected to grow 6%. And the delta between that is your operating margin contraction. And that's really illustrative of the dynamic that we talked about earlier, where companies are not all able to pass through those rising input costs that they're seeing.

So there are supply chain issues where companies can't get parts, but there are also just more expensive inputs across the board, whether it's transportation, logistics, fuel, energy, steel, and so forth, and not to mention labor. So as we see inflation across the board for companies, we expect margins to continue to be under pressure.

And the other thing that means for investing this year is that buy and hold is probably not going to work as well as it has the last three years. The last three years, we've seen high double digit returns in the S&P 500 just from buying and holding the index. And this year, I think you need to be much more nimble and careful and try to find companies that can avoid that operating margin contraction that we're seeing in the broader market.

- So then to that end then, if you're a retail investor, you sort of were trying to sort of jump in and buy the dip when you could, whereas you saw some institutional investors really holding onto their cash, how do you recommend retail investors navigate this space? How should they balance holding in cash as well?

ELLEN HAZEN: I think it always makes sense to put money to work in the ideas that you have found doing your own research when the market gives you those opportunities. And as you're doing your own research, what I would really focus on are companies that have pricing pressure.

And the way you can tell that is if you go to Yahoo Finance and you look at the operating margin over time and find companies who have been able to grow their operating margin, that gives you your shopping list, those companies that have been able to grow operating margins over time. And then you pick your price point and use the volatility that the higher interest rates and the war in Ukraine is introducing, you use that volatility to go shopping at the right price.