Opportunities for when the Fed’s recession knocks

Bottom line up top

As the U.S. Federal Reserve readies for what we think will be its last climb up Rate Hike Mountain, weary investors have already traded in their hiking boots for more comfortable footwear, eyeing a course they hope will be downhill from here. The Fed’s May meeting is merely hours away as we write, with all eyes on the next rate decision and any guidance on future policy. And although the March print showed the Core Personal Consumption Expenditure Index — the Fed’s preferred inflation barometer — remains higher than the central bank would like, we think we may be approaching peak rates.

With that, we expect Fed Chair Jerome Powell to announce a 25 basis points rate increase this week, but then pause on the Fed’s 13-month, anti-inflation tightening campaign. We foresee a mild recession ahead, driven by this aggressive hiking cycle, but we reject the old market mantra, “Sell in May and go away.” Instead, we continue to preach “stay invested,” informed by the relative strength of corporate earnings and the underlying economy, combined with encouraging historical data about investment performance following a Fed pause.

While 2023 earnings forecasts have been revised modestly downward (Figure 1), equity valuations are rebounding on potential monetary policy changes propelled by what may be the most anticipated recession of all time. While equity investors are rooting for rate cuts by year end, rate stability may prove to be the strongest catalyst for positive returns across a broad swath of asset classes (Figure 2).

Portfolio considerations

High hopes for high yield. U.S. high yield corporate bonds are now yielding 8.5% with a duration of less than four years, making them less sensitive to spread widening compared to other fixed income investments. While history may not repeat itself, we think the end of the Fed’s current cycle could be another “pause that refreshes.”

Preferring preferreds. Another attractive spread sector is preferred securities, although this preference is based less on rate stability and more on recent market moves that have created value. March’s banking sector turmoil led preferred spreads to widen by 90 bps. Yet the contagion risks that many initially feared did not materialize, and preferred spreads have retraced only about a third of that widening.

Munis win on appeal. The municipal bond market tends to be among the most vulnerable to rate volatility, as the asset class is prone to outflows during uncertain times, as we saw in 2022. Munis have rebounded this year, with investors rediscovering their appeal as rates slowly stabilize. Within the municipal landscape, we prefer pairing credit risk with duration risk. Municipal credit has strong underlying fundamentals, and a steeper yield curve relative to Treasuries favors longer-duration exposure.

Dialing up dividend growth and infrastructure. Outside of fixed income, while equities have typically rallied after a Fed pause, we continue to favor defensive exposure and sectors that should be relatively resilient if inflation remains stubborn. We emphasize dividend growth and infrastructure equities, both of which tend to perform relatively well during economic slowdowns and recessions. Additionally, infrastructure should be well-insulated from elevated debt costs and inflation.

Prioritizing private credit and real estate. In private capital markets, we prefer allocating to income-producing asset classes with the potential for downside protection. In particular, we see compelling opportunities in select areas of private credit and private real estate.