Markets rally as Fed refrains from hawkish surprise

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

The S&P 500 closed 2.62% higher on Wednesday following the FOMC meeting and Fed Chair Jerome Powell’s comments. New trade and spending data also contributed to the positive investor sentiment and market momentum.

?The S&P 500 ended 2.62% higher on Wednesday despite a second consecutive 75-basis-point rate hike from the Federal Reserve. While the Fed last raised rates at this pace in the 1990s, it held back from a 100bps hike, which had been seen as possible following the 9.1% year-over-year inflation reading for June.

Although Fed Chair Jerome Powell warned that another “unusually large” rate increase may be warranted at the next FOMC meeting in September, he noted that this would depend on the economic data. Powell suggested that the economy had already started to cool, saying that “recent indicators of spending and production have softened,” though he also noted that he did not think the economy was in a recession in light of the strong labor market.

His comments kindled hopes that the Fed could soon be able to reduce the magnitude of future rate hikes. Futures markets scaled back the implied level of hikes for 2022 by around 10bps, and now point to rates ending the year around 3.25%. Ten-year US Treasury yields ended the day flat, while 2-year yields dropped by 6bps, reducing the degree of yield curve inversion.

Powell’s comments added momentum to a market rebound that was already underway. Prior to the Fed’s decision, the S&P had been up around 1.4%, bolstered by better-than-feared results from mega-cap tech companies. Microsoft forecasted that revenue would grow by double-digit rates this fiscal year due to still solid demand for enterprise IT spending. Alphabet, the parent of Google, also reported better-than-feared numbers but did highlight a more “uncertain” macro environment. This lifted the tech sector by 3.3%. Apple and Amazon will report results on Thursday.

The news from the top US tech companies helped reassure investors following a profit warning from Walmart earlier in the week. The retailer had warned of a drag on consumer spending due to higher inflation, which added to worries over the US economic outlook. But this seems to be concentrated in lower-end consumers and shifts within the consumer spending basket. Visa’s results—a broader read on the health of the consumer—suggest spending remains resilient.

Data releases on Wednesday also helped temper economic pessimism. A 5.6% fall in the US trade deficit for June to USD 98.2bn reduced the likelihood that the US economy contracted in the second quarter. Trade has been a drag on GDP for the past seven quarters in a row. Rising exports of crude and oil products, which hit a record 11 million barrels per day last week, contributed to the improving trade balance. The trend underlines that the US is less vulnerable to the impact of the war in Ukraine on energy prices and supplies than Europe, which suffered a further cut in supplies from Russia earlier this week.

Sentiment on the US economy was also helped by data showing that companies’ spending on equipment rose last month. Orders for nondefense capital goods excluding aircraft rose 0.5% month-over-month and 10.1% year-over-year.

What do we expect?

The scale of Wednesday’s rate hike is less important in our view than the Fed’s ability to convince markets that inflation is under control. The 10-year US breakeven inflation rate rose 8bps to 2.44% after the rate announcement as markets digested the prospect of an end to rate increases. But 10-year breakevens are still down from a peak of 3.1% in April.

Federal funds futures markets are now pointing to a policy rate of around 3.25% by year-end, implying roughly 100bps of additional tightening by end-December. The pace of rate hikes will remain contingent on how swiftly inflation moderates, but given that recent growth data has been softening, this gave the market confidence that an inflection point in Fed policy may be drawing closer. That said, while the market rallied Wednesday, we don’t think a sustained improvement in sentiment is likely until the Fed sees enough evidence of ebbing inflation to signal that an end to rate rises is in sight.

In addition, while growth sectors have been driving the rise in equities recently as yields have retreated from their peak—the MSCI World Growth Index is up 4.8% so far in July, versus 1.6% for the value index—we don’t see this trend continuing. While inflation is likely to decline in the coming months, it is likely to remain above central bank targets. Data stretching back to 1975 indicates that value sectors tend to outperform when inflation is above 3%, which we expect to be the case for some time to come. Furthermore, growth stocks are still expensive relative to value stocks. The P/E for the Russell 1000 Growth index is 70% higher than the P/E for the Russell 1000 Value index—this valuation spread is double the long term average 35%.

So far, the US second-quarter reporting season is consistent with growth slowing but not sinking. Of the nearly half of companies by market cap that have released results, around 75% have topped earnings forecasts. In terms of guidance, the 3Q EPS estimate is about 1% lower for companies that have reported. So, we are seeing modest earnings cuts, but these are in line with historical patterns.

How do we invest?

We continue to advise investors to treat improvements in market sentiment with caution. A more sustained revival in confidence will likely have to wait until we see more compelling evidence of falling inflation, a less hawkish stance by central banks, and more evidence that economic growth is sustainable. The recent reduction in gas supplies to Europe has added to growth headwinds, while the US earnings season could also generate additional volatility, with around 50% of companies by market cap reporting results this week.

With the economic and political backdrop still uncertain, we advise investors to build a portfolio that is resilient under various scenarios:

Add to defensives and quality, prefer value, and make use of volatility.?To?build up defenses?against a potential "slump" scenario, in which weaker economic data drives lower corporate profit expectations and downside in stocks, we believe investors should add exposure to quality-income stocks, the healthcare sector, resilient credits, and the Swiss franc. With inflation still high, we prefer value stocks, including energy and the UK market. Capital-protected strategies may also allow investors to use volatility to work in their favor and mitigate potential downside risks.

Manage a Liquidity strategy and diversify with hedge funds.?As the basis of a strong portfolio, to manage the risk of forced selling, earn yield, and prepare for potential future opportunities, investors should build and manage a Liquidity* portfolio, sized to meet 3–5 years of cash flow needs. This will likely consist of a mix of cash, cash alternatives, and short-duration bonds. Investors should also ensure an adequate allocation to hedge funds, which have the potential to deliver performance, even if both bonds and equities are falling.?Click here?for more.

Position for the era of security.?The move this week by Russia to further restrict gas supplies to Europe will add to the focus on energy security in Europe and beyond. We see this as part of a broader trend in which governments and companies will focus more on safety and security over pure considerations of price and efficiency. This is likely to affect areas as diverse as energy, food, and cybersecurity.?Click here?for more.

*Timeframes may vary. Strategies are subject to individual client goals, objectives, and suitability. This approach is not a promise or guarantee that wealth, or any financial results, can or will be achieved.

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