Investing amid a front-loaded hiking cycle

The trend toward oversized rate hikes has continued over the past week, with the European Central Bank and Bank of Canada both delivering 75-basis-point increases. Market expectations have also ticked up that the Federal Reserve is likely to opt for a third consecutive 75-basis-point rate rise at its meeting on 20–21 September, after Chicago Fed President Charles Evans said last week that this “could very well” be the outcome. Fed Chair Jerome Powell emphasized that curbing inflation would require the central bank to “act now, forthrightly.”

While we expect the August CPI release this week to provide further evidence that US inflation is easing, peak inflation has not yet been reached in the Eurozone or UK, in our view. And we believe the Fed will require at least three months of reassuring inflation data—along with evidence of a cooling labor market—before considering softening its tone.

Against this backdrop, we see relatively limited upside to equity markets out to June 2023, requiring investors to add exposure more selectively. We favor strategies that can perform well under a variety of scenarios:

Seek parts of the market that are resilient as growth slows.

• Central bank tightening is just one of several headwinds to growth. The threat of energy shortages in Europe has increased following the recent decision of Russia to halt flows through the Nord Stream 1 pipeline. Meanwhile, COVID-related mobility restrictions in China remain a drag on the world’s second largest economy. As a result, we favor tilting toward more defensive parts of the equity market, high grade bonds, and the Swiss franc. We retain a least preferred stance on the euro. Given the headwinds to Eurozone economic growth and concerns about the region’s energy supply, we do not think the ECB’s fast track toward policy normalization will be enough to prevent renewed weakness in the currency heading into the winter.
• Within equities, we continue to prefer the global healthcare sector 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.

Value is well-placed to outperform growth.

• While central banks around the world are front-loading rate hikes, inflation will remain above target for some time to come. The latest ECB forecast, for example, now has inflation above the 2% target out to 2024, with 8.1% for 2022 overall and 5.3% in 2023. Such periods of elevated inflation have historically been associated with value sectors outperforming growth.
• Notably, we favor the energy sector. While oil demand will be dented by slowing global growth, we still expect a rebound after the recent fall in prices, which has taken Brent from 105 a barrel in late August to USD 94 at present. This view is supported by the rising use of oil in power generation—amid high prices or limited supplies of gas and coal—along with an ending of sales from government strategic reserves later in the year and a phasing out of imports from Russia by European nations.

Prepare portfolios for further volatility.

• The Fed has made it clear that its priority is fighting inflation, even at the cost of economic pain. And the ECB has indicated that it favors front-loading rate hikes. That is likely to lead to further market volatility, in our view. 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.

So, the swift pace of tightening by central banks is no reason to sit on the sidelines in markets and opportunities remain. We also suggest investors consider alternative forms of diversification in volatile markets, such as hedge funds and private markets.

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