With the Fed on pause, a good defence can be the best offence
As the Fed signals the end of its hiking cycle, here are 3 reasons to stay on the defensive.
But that doesn’t necessarily mean it’s time to pile into riskier assets. In our view, it still makes sense to stay defensively positioned for three key reasons:
- Fast rate hikes are putting pressure on the economy. When central banks raise rates quickly, the impact of those hikes can expose vulnerabilities in weaker parts of the economy and financial system. We’re seeing that play out now with the stress in US regional banks, and it’s still unclear how the situation will evolve.
- ERAA® shows we’re still in stagflation. Our Economic Regime-based Asset Allocation (ERAA®) investment model continues to put us in stagflation – historically, a difficult environment for investing. The latest economic data continue to validate that picture.
- Equity investors may still be overly optimistic. Markets are flashing mixed signals on what’s to come, with interest rate markets bracing for a further slowdown ahead and equity markets painting a rosier picture. This means that equities could see more downside if the economy slows, as leading indicators suggest.
So what comes next, and what does that mean for markets? Let’s dig in.
First off, let’s look at the Fed’s current state of play
As of May, the fed funds rate now stands at a range of 5-5.25%, bringing cumulative hikes to 500 bps since March 2022. More importantly, at its latest meeting, the Fed dropped language saying that it anticipated further rate hikes would be needed. This is a strong signal that the US central bank is ready to keep rates on hold.
What about rate cuts? At his post-decision press conference, Fed Chair Jerome Powell stressed that those are unlikely to happen in 2023. That stands in sharp contrast with interest rate markets, which are still pricing in cuts starting as soon as the second half of the year on increasing expectations of a US recession. (That’s just around the corner!)
Hike fast and break things?
After such an aggressive rate hike campaign from the Fed – its fastest since the 1980s – the risk that something in the economy will break is very high.
That’s because when a central bank raises interest rates too fast or too high, it can put pressure on the weaker parts of the economy. Let’s look at an example from recent history: in 2007-08, vulnerabilities in subprime mortgages rippled out across the broader financial system via mortgage-backed securities (MBS).
This time around, we’re seeing stress in the US regional banking system following the collapse of Silicon Valley Bank (SVB). This phenomenon hasn’t been limited to the US, either: the Bank of England’s rate hike cycle contributed to the mayhem in the UK pension system late last year.
Stagflation to keep the Fed on pause and investors on guard
The most recent batch of data adds to that picture:
- When it comes to growth, US GDP expanded an annualised 1.1% in the first quarter of 2023, slowing from 2.6% in Q4 2022, and coming in well below the consensus forecast of a 1.9% increase. The ISM Manufacturing Purchasing Managers Index (PMI) – a gauge of factory activity – remained in contraction in April. Keep in mind that slowing down economic growth in order to rein in inflation is exactly what the Fed wants. (Find out more about our outlook for growth in April’s CIO Insights.)
- At the same time, inflationary pressures remain stubbornly high. Headline and core CPI inflation inched down only slightly in April to 4.9% and 5.5% year-on-year (YoY), respectively. Core PCE inflation – the Fed’s preferred gauge – also edged down to 4.6% YoY as of March. Wage growth is another big area of concern for the Fed, and the Employment Cost Index (ECI) showed that it picked up to an annualised 4.7% in Q1. This all suggests it will take more work to get inflation back to the Fed’s 2% target.
These persistent inflationary pressures help to explain why the Fed has pressed on with rate hikes even amid ongoing turmoil in the US banking sector. This is also why the Fed is more likely to keep rates steady rather than cut them in the near-term, especially if growth slides but inflation remains above target.
Powell stressed this during his press conference, noting that inflation will take some time to come down – in which case, “it would not be appropriate to cut rates and we won’t cut rates.”
Equity investors may be too optimistic given the risks ahead
Despite the high uncertainty ahead, US equity valuations and earnings estimates are still quite buoyant:
- On valuations – which reflect the price that investors are willing to pay for an asset – the S&P 500’s forward 12-month price-to-earnings (PE) ratio is still broadly in line with its 20-year average of about 18.5x. Especially given recession risks, those valuations appear elevated.
- On earnings, the market consensus is currently projecting a decline of just under 1% in the S&P 500’s earnings per share (EPS) for 2023. To put that into context, previous recessions have seen EPS slump 16% on average. The potential for downward revisions to EPS is another risk for equity markets.
Paradoxically, part of the reason why equity investors may be more optimistic is because of the prospect of a recession. That’s probably because fast rate hike cycles – or those where the Fed raised rates for consecutive months – have typically been followed by fast rate cuts. And as central banks come to the rescue with liquidity, investors may see this as supportive for stocks.
However, history shows that equity returns have tended to be negative both before and after the start of rate cuts that followed fast rate hike cycles. In the 180 days leading up to the Fed’s first rate cut during such cycles, median returns for the S&P 500 amounted to -7.5%. And in the 180 days after its first cut, median returns were -6.7%. This makes sense given that deteriorating macroeconomic conditions generally accompanied these episodes.
What’s more, it also shows that when the Fed has hit pause on rates, that pause has typically lasted 6.5 months on average. Stubborn inflation and hawkish signals from the Fed suggest a sustained rate hold is likely this time around – which wouldn’t be a supportive environment for stocks either.
Put it together and this suggests that equity investors may be getting ahead of themselves, and shows why now isn’t the time to take on additional risk by piling into equities.
This uncertain economic environment warrants a defensive positioning
- In fixed income, short-duration US government bonds remain attractive due to their low risk and high yields as the Fed is likely to keep rates steady. However, we are keeping a close eye on longer-duration US bonds as they could outperform as growth deteriorates, inflation slows further, and the prospect of rate cuts starts to materialise.
- For equities, ERAA® continues to favour defensive sectors like healthcare, while exposure to emerging market (EM) equities also helps to capture the better growth dynamics outside the US.
Markets may be uncertain, but investing doesn’t have to be
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