If a week is a long time in politics, then a month can be an eternity in financial markets. After ducking behind terms including ‘patience’ and ‘transitory’ the Reserve Bank of Australia (RBA) and US Federal Reserve (Fed) have been forced out of hiding, humbled by rampant inflation.
Only a month ago debate raged about whether a 50bps hike from the Fed was warranted. A few weeks later that figure had shifted to 75bps with similar increases not discounted at future meetings. As it transpired the Fed shifted the policy rate by 50bps at its May meeting and cleared the path towards reaching a neutral policy rate (the level deemed to be neither contractionary nor expansionary) by year-end. While many market estimates have this figure sitting around 3%, others have it much higher - which may not be bad for equities over the short-to-medium term given it decreases the risk of the Fed taking rates too quickly into contractionary territory. That said, if neutral is reached by year-end it would mark one of the most abrupt shifts in Fed policy history and carry with it the risks that accompany such a sharp change - namely overtightening and plunging the economy into recession. It has been an incredible about-turn from the world’s most influential central bank.
Perhaps the only central bank looking more embarrassed is that of our own, the RBA, forced to eat humble pie after as recently as November 2021 it noted “…the first increase in the cash rate being in 2024”. Where little more than a month ago the RBA was preaching ‘patience’, last week it hiked the cash rate for the first time in more than a decade. Like the Fed, it too has set course for rapid fire tightening with many estimates of an official cash rate of between 1% and 2% expected by year-end.
There is a general assumption that rate rises aren’t good for equities as they drag on valuations - many equity valuation methods incorporate the discounted cash flow model whereby an increase in interest rates will also increase the discount rate. Therefore, if rates go up, stock prices must go down - or so the theory goes. Not always, particularly when the hiking cycle has started from a relatively low base as is the case now. In fact, four of the past five US tightening cycles have seen equities rise across the period. Rather, increasing rates tend to lead to aggressive sector rotations and increased volatility in the short-term. This is because rates aren’t the only factor impacting equity prices.
Cumulative returns over different time periods
Source: Dow Jones Market Data
Inflation is currently running hot. Much is made of the supply-side constraints; however, the reality is consumer demand remains incredibly strong owing to fiscal stimulus, record employment levels, increased household savings and near-zero borrowing costs. This has allowed corporations to pass increased costs through to consumers with earnings remaining relatively strong - for now.
Currently, the war in Ukraine is expected to increase inflation rather than damage growth prospects. We see inflation nearing its peak (but remaining elevated) in the US thanks to base effects, the continued reversion from goods to services spending and an easing of supply chain issues over the medium-term.
In short, it is the macroeconomic backdrop under which rates rise which is important. Rising rates alone doesn’t necessarily sound a negative signal for equities. If inflation can be brought under control without stifling the economy, then the macro environment should remain positive and equities are likely to remain supported by strong corporate profits.
Given much, if not all the hawkishness is already priced into markets, should inflation recede it could provide the Fed with some breathing room and allow the opportunity for another about-turn (dovish this time). If this occurs, equities could pop from their current lows.
As noted at the start of 2022, the unwind of the extraordinary fiscal and monetary policy unleashed at the onset of the pandemic will test central banks. As long as the impacts from the war in Ukraine, lockdowns in China, and eventual tightening cycle remain opaque; markets will remain volatile.
What this means for our diversified portfolios
We remain in a ‘wait and see’ mode. Many equity markets have hit or tested year-to-date lows in the past month. Given this, we believe the downside risk is somewhat capped in the near-term. We would likely need another exogenous shock or for the Fed to send the US into a dramatic recession by tightening too swiftly (something we see as unlikely anytime soon) for markets to capitulate.
Conversely, to upgrade risk we would need to see central banks roll over to a dovish narrative. Again, we are probably too early for that scenario.
As such, in a rising rate environment that is accompanied by strong inflationary pressures we see equities outperforming bonds. For that reason, we retain our very mild preference for equities and mild dislike for duration. We continue to monitor markets closely and remain in regular dialogue with our asset consultants and fund managers.