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Fed fatigue

Private Bank

2024-05-10 00:00

Rates markets have conceded that monetary policy will likely remain restrictive for longer, while equity markets appear to be growing tired of waiting for rate cuts to materialise. The current Fed pause is the second longest on record, and while longer pauses are typically constructive for equities, the period following the first cut is not always. Our Chief Investment Office explains further. 

In last month’s House View we noted that stagflation cannot yet be ruled out. Before month-end investors were expressing similar concerns as core US inflation printed above expectations at 0.4 per cent month-on-month and first quarter growth moderated more than expected, increasing at an annualised rate of 1.6 per cent - the slowest pace since the second quarter of 2022.

This saw bond yields rise sharply over the month as rates markets dialled back expectations for the timing and quantum of US Federal Reserve (Fed) easing before year-end. As for equities, after shrugging off the significant repricing of forward curves over the first quarter of the year, investors suddenly appeared tired of waiting for the Fed to deliver interest rate reprieve - the S&P 500 finished April 4.1 per cent lower, snapping a five-month winning streak. 

Attention now turns to whether the Fed will face the predicament of prioritising price stability or economic growth. Given that until now employment has remained robust, equities strong and growth resilient, the Fed has still not been tested this cycle. 

Still, this dilemma may not come to pass. The longer-term disinflation trend appears in-tact (just) and Fed Chair Powell noted at his post-FOMC press conference that the Fed is confident that policy is “sufficiently restrictive.” Last week’s underwhelming non-farm payrolls print and tick up in the unemployment rate show he may yet be proven right.

Of course, how long the economy can sustain these higher rates and whether corporate earnings will eventually succumb to this pressure remains the million-dollar question. 

Looking at earnings results so far this reporting season, it appears US corporates are coping - for now. With more than 80 per cent of companies in the S&P 500 having reported, growth remains solid at 5.0 per cent. Additionally, revenue growth estimates are showing an expected acceleration over the coming 12-months. While revenue growth should be positive for equities if delivered; in our view, the quality of earnings remains questionable, given volumes are down and prices are higher - a dynamic not typically sustainable for extended periods - and one that also suggests interest rates will remain elevated. Furthermore, the savings rate has fallen towards pre-GFC lows, excess pandemic savings are dwindling, and credit card usage is up 15 per cent year-on-year - with delinquencies rising.  

Then there is geopolitics. Middle East tensions appear to be contained for now, and barring further conflagration the expected inflationary impact is expected to be modest. However, the conflict is a stark reminder of why countries are adopting greater protectionist policies and economic and national security are becoming increasingly prioritised. European parliamentary elections next month are expected to deliver big gains to right-wing populists and November’s US election will focus heavily on immigration, tariffs and taxes. Even Australia’s own ‘Future Made in Australia’ has hallmarks of such protectionism. 

One beneficiary of this uncertainty has been gold. Typically, rising real yields and a strong greenback spell trouble for the precious metal, but safe haven demand is rising, and some governments and central banks are looking to diversify their reserve assets away from the US dollar. For investors, the asset class can play a similar role during periods of uncertainty, helping add diversification to portfolios given its historically low or negative correlation to most other asset classes.

On a more positive note, price pressures continue to exhibit a clear disinflation trend in Europe and growth has also picked up there recently too - albeit from miserly levels. Indeed, the ECB appears on track to cut rates from as early as next month. And although US rates may remain at current levels for some time, we have likely seen a peak in the Fed funds rate this cycle. A factor contributing to our exposure to duration.

As the below chart shows, the peak in US Treasury yields typically coincides with the peak in the Fed Funds rate. Yields rose substantially over April and although we can’t rule out a return to 5 per cent, we would probably need to see another rate hike from the Fed for yields to breach that level once more. And as Chair Powell said in his post-FOMC press conference, “it’s unlikely that the next policy rate move will be a hike”. 

Given inflation dynamics and the rise in yields, the hurdle for equities to keep rising without restraint has arguably lifted. Longer rate pauses have typically been a constructive environment for equities, instead it is the initial cutting phase that tends to trouble stock markets. Indeed, on average the S&P 500 has fallen more than -23 per cent over 200 days following the first rate cut in a series. The current pause is the second longest on record and while its continuation may allow equities to keep climbing, the further it extends, the more likely that rate cuts are forced upon the Fed rather than delivered by its own volition.  

Though a further sell-off across rates markets is possible, given the recent tick up in yields we expect downwards pressure to be somewhat capped. Considering the continued uncertainty surrounding inflation and rising geopolitical tensions, we believe that the yields currently available across high quality bonds mean fixed income provides the opportunity for better risk-adjusted returns at this point in the cycle. 

Peak in US Treasury yields typically coincides with the peak Fed Funds rate


What this means for our diversified portfolios

With inflation remaining sticky and yields climbing to more attractive levels, we increased our exposure to duration across portfolios in April. The change was implemented across the US Treasury market, with concentration in the middle part of the curve, specifically via inflation-protected securities or ‘linkers’. Although we are lengthening duration, should inflation continue to surprise to the upside and rates end up rising as a result, linkers should outperform nominal bonds in this environment. 

While we remain broadly neutral towards equities, the potential for a higher for longer rate environment does bring increasing uncertainty for markets. As such, we also lifted our exposure to alternative assets as a means of providing greater diversification to portfolios. The position was implemented via gold and made with a view towards a standalone gold exposure being included as part of a revised strategic asset allocation in the second half of this year. 

While the price of the precious metal has risen substantially over the start of the year, the position is not an outright directional trade, rather it is focused on improving the risk characteristics of the portfolio. Our investment philosophy articulates that a whole of portfolio approach should be adopted when investing. Not every asset in a portfolio is included solely to generate returns. To withstand various market environments, portfolios should include assets that are held to protect portfolios when scenarios do not go according to expectation. Gold is one example of this.

Across portfolios we remain defensively positioned overall with a benchmark position in equities, overweights to domestic and global fixed income and a large underweight to high yield credit.

If you’d like a copy of our full House View, please speak to your ANZ Private banker or advisor.

Fed fatigue
Chief Investment Office
Private Bank

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