Equities fall on no Fed pivot

Originally published as CIO Alert by Mark Haefele, Chief Investment Officer for UBS Global Wealth Management

What happened?

The S&P 500 fell 3.4% on Friday, after Federal Reserve President Jerome Powell said it would likely be necessary to keep monetary policy restrictive “for some time” to bring inflation back under control. In a speech at the central bank’s annual Jackson Hole Symposium, Powell pushed back against recent market hopes that ebbing inflation pressures could allow the Fed to pivot toward rate cuts early next year. “The historical record cautions strongly against prematurely loosening policy,” he said.

The hawkish comments echoed those from other top Fed officials in recent weeks and dented market sentiment following a 17% rally in US stocks from June’s lows. Friday’s fall left the S&P 500 5.8% below a recent peak in mid-August. The technology-heavy Nasdaq Composite, which is more vulnerable to higher interest rates, fell 3.9% on Friday and is now down 7.5% from its recent high earlier this month.

While the equity market responded negatively to Powell’s comments, bond markets appeared better prepared for the hawkish tone. The yield on 2-year US Treasuries ended Friday just 2 basis points (bps) higher at 3.39%, having initially risen 5bps following the speech.

Fed funds futures were also little moved on the day, although they have adjusted over recent weeks to reflect a lower probability that the central bank will be able to start cutting rates in 2023. As recently as mid-July, futures had been implying over 80bps worth of rate cuts next year, starting as early as March.?Now they are implying 30bps worth of cuts next year, with the first cut around November.

As for the currency markets, the broad US dollar index gained only modestly—less than 0.5%—on the back of Jerome Powell’s speech. Highly pro-growth currencies, such as the Australian dollar, New Zealand dollar or Norwegian krone slid the most with the euro stable.

Jackson Hole talk overshadowed encouraging data that July may have marked a turning point in inflation. In data released just ahead of Powell's speech, the PCE deflator, which is the Fed's preferred inflation measure, surprised to the downside, falling 0.1% month-over-month in July, with core PCE edging up just 0.1%. Powell said, “While the lower inflation readings for July are welcome, a single month's improvement falls far short of what the Committee will need to see before we are confident that inflation is moving down.”

Powell also noted the importance of inflation expectations. Just as he started his speech, the University of Michigan's Survey of Consumers showed five to 10-year inflation expectations holding steady at 2.9%, a reading compatible with the Fed’s target for PCE.

What do we expect?

In our recent CIO letter, we noted that investors had started to underestimate the willingness of central banks to tighten policy at current rates of inflation. The market’s reaction to Powell’s comments is consistent with this observation.

We maintain our view that the Fed will raise rates by another 100bps by year-end, with risks for more if inflation does not slow in line with our forecasts.

With rates likely to stay higher for longer, our base case is for further volatility, earnings downgrades, and higher-than-expected default rates over the course of the next year. As Powell cautioned “while higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses.”

Our price target for the S&P 500 in June 2023 is 4,200, versus 4,057 as of Friday’s close, with the 10-year Treasury yield at 2.75%, compared to 3.03% at present. Meanwhile, uncertainty remains high over the course of inflation, energy prices, the war in Ukraine, and economic policy in China, so investors should remain alert to the risk of more adverse scenarios. We see this as a time to be selective in equities.

Despite this uncertain backdrop, there is plenty that investors can do to prepare portfolios for a variety of eventualities while focusing on long-term returns. Investors should consider the opportunity cost of sitting on the sidelines.

How to invest?

In this environment we recommend investors take a selective approach, including:

Invest in value.?We expect consumer price inflation to remain above central bank targets for some time. Periods of elevated inflation have been associated with an outperformance by value relative to growth sectors, as has been the case so far in 2022. We favor global value, and the UK equity market, which has a high exposure to value sectors. In addition, we expect energy stocks to benefit from a renewed rise in oil prices, along with rising share buybacks and attractive dividends.?Click here?for more.

Add defensives and quality.?With US growth likely to slow below trend, while the Eurozone and UK look set to experience recessions, investors should consider adding exposure to more defensive parts of the equity market, high grade bonds, and the Swiss franc. We continue to prefer healthcare as we believe it offers attractive long-term growth, appealing shareholder returns, and a defensive quality profile at a reasonable price. We also like consumer staples. The sector is traditionally well positioned for an economic slowdown and tends to outperform the overall market when leading indicators, such as the ISM, weaken.?Click here?for more.

Make use of volatility.?The Fed’s signal that it is willing to tolerate economic pain to bring down inflation is likely to lead to further volatility ahead. We view both capital protection and dynamic asset allocation as good ways to position more defensively. Meanwhile, we see opportunities to generate yield amid elevated currency, commodity, and equity market volatility. For example, in commodities, we see an opportunity in selling downside price risks in Brent crude and copper. A downward-sloping futures curve and our view that oil prices are likely to remain high for an extended period speak in favor of such a strategy.?Click here?for more.

Be selective in long-term growth.?Growth stocks remain sensitive to changing expectations around inflation and interest rates, and so we advocate selectivity within growth at this stage. We recently opened a new theme focused on the "circular economy" discussing the investment opportunity in waste management and collection (recycle), plastics (reduce), and resale as a service (reuse). We think companies embracing ‘circularity’ stand to benefit from changing regulation, shifting consumer preferences, resource scarcity and cost pressures, and technological innovation.?Click here?for more.

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