Asset Allocation During Rising Inflation and Aggressive Policy Tightening

Summary: Reviewing all twelve monetary tightening cycles since 1955 allows us to analyse how markets typically perform in the one-year period from the initial rate hike. Four of those cycles are particularly relevant for the current macro regime. The common pattern during these episodes was commodities outperforming equities, equities outperforming cash, and cash outperforming bonds (with credit outperforming government bonds). If history rhymes this year, commodities and value stocks stand the best chance of delivering positive real returns in this challenging market environment.

Seven out of these twelve Fed rate hike cycles occurred during the reflationary period between 1950s and 1981, whereas the other five cycles took place during the disinflationary years from 1981 until 2020. During the reflationary period, consumer prices were at first increasing at seemingly benign rates, but they gradually escalated to double-digit levels, prompting the Fed to impose a severely restrictive monetary policy in 1980/1981 to halt the inflationary spiral for good. In the disinflationary decades that followed, both interest and inflation rates drifted lower over time, reaching lower lows and lower highs with each cycle.

Separately, we can also distinguish between “fast” hiking cycles, where the effective Fed Funds rate rose by more than 2%, from “slow” cycles when the cumulative increase was less than 2% over the first 12 months. Notably, only two out of the twelve hiking cycles resulted in recession within the first twelve months from the initial hike, and both of these were fast hiking cycles in inflationary environments: those commencing in January 1973 and in September 1980.

Historical observations

Across these twelve scenarios, cash rates rose by 1.6% in the first 12 months, and 10 year yields rose by 0.5% on average, implying 1.1% flattening of the yield curve. The flattening pattern was fairly consistent across the different cycles. Credit spreads tightened by 0.2% during the first 12 months of fast hiking cycles, but they widened by a similar magnitude during slow hiking cycles. On average, across all 12 scenarios, credit spreads were little changed, though we observe a degree of spread widening in disinflationary environments and a slight tightening in reflationary episodes. This is consistent with economic logic, as rising inflation reduces the real debt burden and results in lower defaults.

Corporate earnings rose by an average of 19.3% during the first 12 months of all rate hikes, as the economy continued to expand at rates that justified the tightening of monetary policy. The pattern of rising earnings is consistent across all historical hiking cycles, though somewhat stronger in disinflationary environments. Falling inflation rates are generally supportive for earnings, as associated rate cuts result in lower discount rates, while earnings growth adjust more slowly due to price stickiness.

Various equity sectors respond differently to cyclical market dynamics. Due to the evolving sector composition, we can simulate historical S&P 500 returns across these historical periods on the basis on present sector weights. In most scenarios, equity markets posted double digit returns during the first 12 months of rate hikes, in spite of some initial volatility. The notable exceptions were the 1973 and 1980 hikes where the returns were -24.2% and -18.2%, respectively. As noted previously, these were the only two hiking cycles where a recession occurred within the first 12 months since the initial hike. Value stocks outperformed growth stocks in 9 out of 12 hike cycles by 10% on average, and while that outperformance was consistent across all environments, it was particularly pronounced during fast hiking cycles.

The most consistent pattern across these historical episodes is rise of commodity prices, which on average outperformed cash returns by 12.2%. Their performance was particularly high during fast hiking episodes, reflecting strong aggregate demand across the commodity complex.

Implications for the current market environment

?With the annual inflation rate approaching the double digits, and around 2% worth of additional Fed hikes priced in by early 2023, the current situation looks like a ‘reflationary environment with a fast hiking pace’ scenario. In similar historical scenarios, the overall asset class ranking prefers commodities over equities, equities over cash, and cash over bonds (with a preference for credit).

Commodities: On average, commodity prices rose by 25% in excess of cash during fast hiking cycles in reflationary environments. Thus far, they are up 10% since the initial rate hike this year, implying further upside from these levels. The exception to rising commodity prices was the September 1980 scenario, when the Fed deliberately triggered a recession in order to stop inflation for good. Thus far, the Fed remains of an opinion that a recession will not be necessary to rein in inflation in this instance.

Equities: If historical patterns persist, corporate earnings will grow by slightly less than average because of rising costs, but still at a healthy rate (14% on average). Sharply rising discount rates should continue to trigger bursts of volatility, and brief equity selloffs are common during the early phases of rate hikes. The average equity performance during fast hikes in inflationary environments was 2.8% in excess of cash, which is substantially below the average of 7.7% across all rate hike periods. The top quintile of value stocks on average returned as much as 17% in these environments, as rising discount rates are far less damaging for value stocks vs “long duration” growth stocks. The S&P 500 is currently down around 9% since the first rate hike and value stocks are down 4%, suggesting a lot is already in the price. As an analogy, the August 1977 hike initially triggered a 10% sell-off in in the S&P 500 before rebounding and returning +14.2% at the end of the 12-month period.

Cash: It would be reasonable to expect continued volatility as markets fully adjust to the ongoing generational macroeconomic regime shift and global disruption. Against this backdrop, cash is positioned to deliver slowly rising nominal returns with rising rates. However, real returns on cash holdings are likely to be negative for the foreseeable future. Consumer prices have consistently and substantially outpaced cash returns during similar market environments.

Fixed income: Credit is likely to outperform government bonds, as inflation generally reduces the probability of default and credit spreads tend to tighten by an average of 26 basis points in reflationary environments with fast rate hikes. The underlying government bond yields, however, typically sell off by close to 150 basis points on average, which would result in negative total returns for both credit and government bonds. Thus far in the current cycle, the 10-year yield is up around 60 basis points, and credit spreads are broadly unchanged since the Fed’s initial hike in March 2022.?