Renewed rate hike fears weigh on stocks

What happened?

US equities fell, short-term bond yields rose, and the US yield curve inversion deepened following hawkish Congressional testimony from Fed Chair Jerome Powell on Tuesday. In prepared remarks, Powell said “the ultimate level of interest rates is likely to be higher than previously anticipated,” and that the Fed would be prepared to increase rates at a faster pace if warranted by the “totality” of the data. 

The S&P 500 fell 1.5% and the tech-heavy Nasdaq 1.3%. The decline was broad-based, with all S&P 500 sectors closing lower. The risk-off tone has carried through to the Asia session, with the Hang Seng Index down 2.4% and the DXY US dollar index up 0.2% at 105.8pts. 

Fed funds futures markets moved to price in additional tightening, with the terminal policy rate now expected to hit 5.63% in October, later than previously expected. As recently as the start of February, markets were implying a peak in rates of 4.8%. Two-year US Treasury yields rose by 12 basis points to 5.07%, but yields on 10-year US Treasuries were unchanged on concerns that more aggressive tightening could push the economy into recession. As a result, the yield premium on 2-year Treasuries over the 10-year equivalent is near 108bps, the most inverted the yield curve has been since 1981. 

What do we expect?

The overall tone of Powell’s testimony was hawkish. His statement suggests that following the 25bps hike at the previous meeting, the Fed might go back to more rapid hikes. During the Q&A, Powell said that there were some upcoming data releases that could affect the Fed's decision. We believe that the most important releases are Wednesday's data on job openings, Friday's monthly labor report, and the CPI on 14 March. 

In our view, the Fed's preference would be to stay with 25bps moves for the remainder of the hiking cycle. However, if upcoming data is too strong, then the Fed could feel compelled to hike by 50bps. Futures markets are currently pricing in a 73.5% chance of a 50bps move on 22 March and is almost fully pricing 75bps of hikes by the following meeting on 3 May. 

At this month’s FOMC meeting, the Fed will also provide new interest rate forecasts. In December, the median projection for end-2023 was 5.1%, around 50bps above the current fed funds rate. We expect the median to rise by 25 or 50bps. 

The jury is still out on whether the US economy is heading for a soft or a hard landing. But the combination of a solid economy and above-target inflation is likely to increase the Fed’s conviction to continue hiking rates to, or beyond, the point that would push the economy into recession. Uncertainty about the trajectory for inflation, monetary policy, and economic growth is likely to keep markets choppy in the months ahead. 

How do we invest?

We continue to expect 2023 to be a year of inflections for inflation, monetary policy, and economic growth. But recent developments have reinforced our view that inflection points are unlikely to be reached in unison. Investors will therefore need to take a more regionally selective approach to risk decisions, rather than make blanket “risk-on” or “risk-off” calls. 

Our positioning reflects this and incorporates select relative value opportunities that should enable investors to position for inflections across global markets, while reducing downside risks. 

• We prefer higher-quality fixed income. We think that all-in yields in the fixed income space remain appealing, particularly relative to opportunities in other asset classes. Investor demand for fixed income exposure has also increased. We maintain a preference for high grade (HG) and investment grade corporate bonds (IG). In corporate high yield (HY), slower economic growth and earnings in developed economies suggest higher default risk in the future, and we have a least preferred stance on HY.
  

• Diverging inflections mean we advocate diversifying beyond the US. We expect emerging market equities and early cyclical equity markets, such as Germany, to perform better than US equities. The US economy’s resilience may raise the risk of a later, deeper recession as the Fed presses ahead with its efforts to combat inflation. By contrast, China appears poised for an upswing in growth as economic momentum picks up following the dismantling of COVID restrictions. Domestic consumption is rebounding, and we expect it to support Chinese GDP growth of closer to 5.5% this year, as well as provide a positive catalyst for other emerging markets.

• Value stocks, including the energy sector, should be relatively resilient if inflation remains stubborn. Value stocks have historically outperformed growth stocks when inflation is above 3% and in the 12 months following the final Fed rate hike of a cycle. Meanwhile, tech, the largest growth sector, is likely to be hampered by a further slowdown in earnings growth due to a weaker enterprise outlook and slowing consumer demand, while valuations are demanding.

• Risks to the US economic outlook mean we recommend a selective defensive exposure. We prefer the global consumer staples sector, where relative earnings momentum is positive and strengthening.

• Hedge funds can provide diversification. Monetary policy expectations are likely to remain a key market driver, which can lead both equities and bonds to move in tandem, as has been the case in recent months. This means that less-correlated hedge fund strategies such as macro, equity market neutral, and multi-strategy funds may continue to play an important role in helping diversify portfolios.