Faster Fed rate hikes: Our views

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

What happened?

Equities and bonds rallied after the Federal Reserve raised the federal funds target range by 75 basis points to 1.5–1.75%. The S&P 500 closed 1.46% higher on Wednesday, curbing its losses over the past week to 7.9%. The tech-heavy Nasdaq index, which has been hit harder by rising yields, closed 2.5% higher.

The Fed indicated that the faster pace of tightening could continue at the July meeting, while its updated economic projections pointed to a likely slowdown in the economy. The median Fed projection puts the fed funds rate at 3.4% by the end of the year, and GDP growth is expected to slow to a below-trend rate of 1.7%.

Bond yields declined on the day, with yields on 2-year and 10-year US Treasuries down by 22bps and 19bps, respectively, albeit still 40bps and 25bps higher than last week’s levels. The trade-weighted US dollar, which has been trading near 20-year highs based on the DXY dollar index, depreciated by 0.6%.

Earlier in Europe, after an ad-hoc meeting to discuss the sell-off in parts of the Eurozone bond market, the European Central Bank issued a statement pledging to act against resurgent risks of bond market fragmentation, saying it “will apply flexibility in reinvesting redemptions coming due” in its portfolio under the pandemic emergency purchase program (PEPP). It did not, however, unveil any new tools.

What do we think?

We see no reason to change our broad investment theme of favoring value over growth, but the events of the past week do increase the difficulty of Fed policy achieving a “softish landing.”

Friday’s CPI data was “bad,” showing an increase in inflation. A “bad” print, of course, does not mean the data cannot deliver a “good” one next month. However, in our view, the bond market’s reaction to the data, bringing 10-year yields toward 3.5% at the start of this week, was a signal to the Fed that it had lost too much of its inflation-fighting credibility. The Fed’s rapid response—a 75bps hike—is a sign that it intends to win that credibility back at a higher risk of recession.

The Fed’s messaging is likely to continue to be hawkish until we see clearer evidence of a deceleration in inflation. The stubbornness of inflation and the shift in the Fed’s reaction function have pushed up expectations on the terminal rate, which at the time of writing is priced at just under 4%. Although the Fed may not need to hike all the way to 4% in practice, the risk that it does so has increased, and with it the risk of a recession.

Taking this into account, we forecast 10-year US Treasury yields to trade at 3.25% by December and acknowledge they may trade even higher in the interim. Volatility in bond markets is likely to continue with each policy announcement and each new data on inflation and inflation expectations. We expect yields to decline more sustainably only in 2023 as inflation fears pass and as the market begins to consider the possibility of future rate cuts to support growth.

With the Fed putting even greater emphasis on fighting inflation, the risks to economic activity are rising. Tighter financial conditions, a result of higher yields, wider credit spreads, and stock market drawdowns, are likely to weigh on output. The rise in mortgage rates to their highest level since 2009 is cooling the housing market. And US economic indicators are pointing to a loss of growth momentum: The Atlanta Fed’s GDPNow forecast for the annualized quarterly growth rate of real GDP in 2Q has dropped from a recent high of 2.5% on 17 May to 0% at the time of writing.

Against this backdrop, we now see less upside for equity markets for the remainder of the year. The rally in stocks after the Fed’s decision reflects some optimism that the central bank’s actions may get inflation under control and reduce the risk of stagflation, as well as a positioning “snapback” after the VIX fell back below 30. Nonetheless, the Fed’s action will have a negative impact on growth and on valuations. To reflect this, we have lowered our base case price target for the S&P 500 to 3,900. This reflects a 2% cut to our 2023 earnings estimate, to USD 235 per share, and a cut in our estimate of the fair forward price-to-earnings ratio to 16.6x from 17.9x, owing to higher expected bond yields.

Meanwhile, in the Eurozone, manufacturing momentum is slowing, and recent new orders data suggest downside risks to consensus earnings estimates, even if strong nominal growth and a weak euro could provide some support to 2022 profits. Renewed uncertainty about the future of Russian gas supplies and the risk of bond market fragmentation add to macro risks, and higher yields are a negative for equity multiples.

The ECB’s emergency meeting and statement this week suggest that central banks will not ignore the risks to financial markets from policy tightening, but we do expect new tools will eventually need to be introduced, and episodes of peripheral bond spread widening are probable. Against this backdrop, we have cut our base case December Euro Stoxx 50 target by 2% to 3,400, implying 4% downside by year-end.

How do we invest?

Manage your liquidity. In volatile markets, effective liquidity management can help mitigate the risk of forced selling to meet obligations and allow investors to capture longer-term opportunities as they arise. We recommend that investors consider holding a high-quality bond ladder that aligns to their planned cash flow needs over the next 3–5 years. By having a ladder, investors can take advantage of higher rates while helping shield themselves from bond market volatility. Click?here?for more.

Build up defensive strategies.?The VIX index has climbed from around 26 at the start of Friday’s trading to around 29 today, implying average daily moves of close to 2% in the S&P 500. To mitigate such large potential swings, investors can focus on more defensive parts of the market and could outperform in the event of recession. We particularly like quality income, dividend-paying stocks, and the healthcare sector. Click?here?for more.

Prepare for further volatility.?High volatility environments may also present opportunities to gain market exposure with potentially attractive alternative payoff structures, using structured investments and options. A dynamic approach to asset allocation, or structures with a degree of capital protection, may also help investors manage downside risks. Click?here?for more.

Add to value-oriented strategies.?Within equities, an environment of rising interest rate expectations and high inflation is favorable for value sectors relative to growth sectors. Historically, during periods when inflation has been above 3%, value sectors have outperformed. We favor the energy sector and the UK market, which is heavily weighted to value stocks. Both have outperformed the broader market this year, and we expect outperformance to continue. Meanwhile, periods of rising real yields tend to be negative for growth stocks. We hold a least preferred view on growth and on the consumer discretionary sector. Click?here?for more.

Diversify with alternatives. The potential for hedge funds to provide uncorrelated returns is particularly valuable when interest rate fears lead to higher equity-bond market correlations. Some hedge fund strategies, such as macro, can also perform well in recessionary scenarios. Meanwhile, the sell-off may be creating an opportunity to build up long-term private equity allocations. The average annual return on global economic growth buyout funds launched a year after a peak in the MSCI All Country World Index has been 18.6%, compared to 8% for vintages launched two years before a peak in public stocks, according to Cambridge Associates’ data since 1995. Click?here?for more.

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