We should not be in any doubt about the US Federal Reserve’s determination to bring down inflation. It had already lost some credibility after it misread the severity of just how much consumer prices would rise after the pandemic. But it is not going to make the same mistake again.
The Fed will do everything in its power to bear down on the cause on inflation that it has some control over, namely, excessive demand. It can’t do anything about the kinks in supply-chain issues. It can’t sort out the energy crisis. But it can dampen demand by making it as hard as possible for us to spend by choking off the supply of money through raising interest rates to eye- watering levels.
If its policy should result in scorching the earth, then that will have to be the price that we will have to pay. The Fed is unlikely to be deterred by the howls of pain from bondholders. It will be deaf to the cries of crypto investors. It will not change course simply because indebted homeowners are squealing from high mortgage rates, even if it should result in defaults, repossessions, and foreclosures.
Stock-market investors have yet to feel the full force of the Fed’s scorched-earth policy. But as interest rates continue to rise, they will demand increasingly higher rates of return for holding shares, which could mean a downward revision of price-to-earnings ratios.
A compression of the PE ratio could result in lower share prices. However, share prices are not only a function of the PE ratio but a function of the earnings per share, too. For income investors, the earnings per share is a far more important driver of dividend growth than the PE ratio.
Over the next few weeks, we should be able to sort out the “haves” from the have-nots. The “haves” are those companies that have the ability to pass on cost increases to customers without fear of losing business to competitors. The “have-nots” won’t be able to do that, easily.
The upshot is that a market downturn can be a good opportunity to pick up shares in wonderful companies at good prices. And that is what long-term investing is all about.
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