In response to a robust job market and gradually declining inflation, the Federal Reserve's assertive tightening measures have sent ripples through both equity markets and investor sentiment. This marks a significant departure from the era when investors could rely on the "Fed put," where the central bank would swiftly inject liquidity at the first signs of financial trouble. The Fed's newfound commitment to keeping interest rates elevated for an extended period has caught many by surprise. This shift has raised concerns about the future of equity markets, particularly in light of the historically high valuations of US stocks.
Since 2008 financial crisis, the Fed had flooded the financial system with enormous liquidity, driving interest rates to near-zero levels. The US money base, which had never exceeded 16% of GDP before the 2007 financial crisis, ballooned to over double that figure. This liquidity surge fuelled speculative excesses, pushing even the most unusual assets, like digital pictures of bored monkeys as an investment alternative!! However, these excesses are now poised for a correction, exerting pressure on asset valuations across various classes.
Historical analysis teaches us that taming inflation requires sustained positive real interest rates, precisely the situation we are now confronting. The yields on 10-year and 30-year Treasury bonds have risen significantly in last two years, exerting huge losses to the fixed income investors. This correction has actually made fixed income securities more appealing. We believe while inflation may be peaking, it will remain sticky and there is a long way to go before reaching fed’s target of 2%. ?There is still one likely rate increase on the horizon, and we do not think the rate cuts will happen as fast as market is expecting. The US government continues to pursue expansionary fiscal policies due to upcoming elections, and investors will continue to demand a premium to continue financing this deficit. However, given we are closer to the peak now, even without a quick rate cut, fixed income securities appear to be in a neutral zone with limited downside risk, offering returns that can outpace inflation over a market cycle. While bond returns will not be front loaded, they can deliver meaningful returns once the Fed starts cutting, perhaps late in 2024 or early 2025.
In contrast, the outlook for equity markets appears less promising. The recent rebound in equity valuations has placed us near the upper end of historical valuation ranges, often associated with significant market peaks. Key factors driving valuations, including growth, profit margins, and interest rates, no longer favour equities.
US corporations have enjoyed consistent margin improvements, lower debt costs, and the ability to pass on cost increases while experiencing productivity growth in last 15 years. However, rising debt costs and inflation now hinder their ability to absorb higher expenses without affecting demand. While AI holds the promise of improving productivity, its impact may not be immediately visible, and it could disrupt pricing dynamics. Moreover, significant bond losses lurk on balance sheets, primarily within the Federal Reserve but also among banks. Despite a robust job market, real consumption is faltering, and early signs of rising defaults in credit cards and auto loans suggest that consumers are depleting their pandemic-induced cash cushions. And additional risks lurk in the form of geo-politics, which while contained right now, can spiral causing some form of destabilisation in the form of higher oil prices, or logistics or supply chain issues etc.
While all this doesn’t mean a market collapse in the near term, the risk-reward ratio for US equities appears unappealing, even without considering geopolitical factors. The Federal Reserve has been slow to reduce its historically bloated balance sheet. As the balance sheet reduction gains momentum, the process of asset price correction is expected to accelerate. Given the limited confidence in long-term returns from current equity valuations and the increasing risks, our preference is to invest in US fixed income securities as a hedge against inflation, and increase duration as the rates go higher from here.
The Federal Reserve's aggressive stance in response to a strong job market and moderating inflation has left financial markets in a state of flux. While fixed income securities seem to be entering a neutral zone with limited downside risk, equity markets face uncertainty and potential headwinds, making them less appealing to investors. For now, investors may protect themselves with good quality credit of short to medium duration and increase duration as signs of a rate cut becomes more clear later next year.
