Thought of the day

What happened?
The Federal Reserve left interest rates unchanged at its policy meeting on Wednesday, breaking an uninterrupted series of 10 rate hikes stretching back to March 2022. But officials signaled further rate hikes were likely given the strength of the labor market and still-high inflation.

The dot plot, which charts the rate expectations of policymakers, suggests that rates will peak at 5.6%, up from 5.1% at the time of the last forecasts in March. That implies two further 25-basis-point hikes this year from the current level of 5–5.25%. The Fed also revised its forecast for inflation higher, putting the core personal consumption expenditures (PCE) measure at 3.9% this year, from a projection of 3.6% in March.

At the press conference, Fed Chair Jerome Powell said the labor market remained “very tight” and “inflation pressures continue to run high.” He added that the risks to inflation were “to the upside.”

A hawkish pause was in line with market expectations, with federal funds futures markets pointing to a roughly 90% chance of rates remaining on hold at the meeting. But the likely extent of rate rises implied by the dot plot was greater than expected.

The S&P 500 Index, which was 0.3% higher ahead of the Fed’s announcement (for a 14% rise year-to-date), ended the day 0.1% higher. The news suggested the Fed may be further away than many had hoped from calling an end to the current rate-hiking cycle. The yield on the 2-year US Treasury, which was trading at 4.63% prior to the announcement, is now just shy of 4.75%.

What we expect?
The meeting added to our conviction that the Fed remains committed to bringing inflation down, will raise rates further if necessary to achieve that goal, and does not intend to start cutting rates anytime soon. Powell repeated that the Fed is data-dependent, and that it will make future policy decisions on a meeting-by-meeting basis.

It also reinforced our view that markets had been underestimating the risk of further Fed tightening. Recent inflation and growth data do not yet justify a final end to hiking, in our view, and our base case is for a 25bps hike at the Fed’s July meeting.

Inflation continues to run well above its 2% target. While CPI data for May showed headline inflation slowing to 4% year-over-year (down from a peak of 9.1% last June), core CPI has risen by 0.4% month-over-month for the last six months, a reminder that the underlying inflation trend is still too strong.

The US labor market still looks very tight. Nonfarm payrolls rose by a stronger-than-expected 339,000 in May, while upwardly revised data for the two prior months lifted the three-month average to 283,000 from an initial 222,000. The latest reading on job openings also showed a surprise increase back above 10 million, and the Atlanta Fed’s wage tracker showed an increase of 6% year-over-year in May, inconsistent with sustained 2% inflation.

But following 500 basis points of tightening over the past 14 months—the fastest pace of tightening in four decades—the Fed has concluded it can afford to await further data before its meeting in six weeks. While an end to Fed rate hikes is still in sight, we believe the market is too complacent about the prospect of an economic soft-landing. The VIX index of implied stock market volatility is at the lowest level since the pandemic. US stocks also recently closed up more than 20% from their October low, satisfying some investors' definition of a bull market.

At the same time, equity valuations fail to reflect the risks to the economy, in our view. The expected US growth slowdown in the second half could hurt corporate revenues. We forecast a year-over-year contraction in corporate earnings and believe consensus earnings estimates are too bullish. Equities also look less appealing from a valuation standpoint, both relative to their own history and versus fixed income. US stocks are trading at 18.4 times forecast earnings for the next 12 months, a 14% premium to the average over the past 15 years.

How do we position?
Against this backdrop, we maintain a least preferred stance on global and US equities and see greater opportunity in bonds. We therefore suggest investors:

Buy quality bonds and income: More-resilient-than-expected economic data has boosted yields in recent weeks, providing investors with a good opportunity to lock in elevated rates as the Fed engages in a balancing act between inflation, full employment, and financial stability. We see opportunities in high grade (government), investment grade, and sustainable bonds, and select senior financial debt. Actively managed fixed income strategies can help investors take advantage of the breadth of opportunity. Earning more durable income is not just about high-quality bonds. Among the riskier parts of fixed income, we like emerging market credit. We also see opportunities in diverse income strategies to balance fixed income exposure. This includes quality dividend-paying equities and yield-generating structured strategies.

Position for dollar weakness: We expect rate differentials between the US dollar and other currencies to narrow, and the dollar’s downtrend to resume in the months ahead.

Diversify with alternatives: We recommend balancing traditional portfolios with an allocation to alternatives. Hedge funds should enable investors to navigate as well as take advantage of dislocations in markets in a period of economic uncertainty. Meanwhile, we believe private markets offer a variety of opportunities to earn income and grow wealth over time, including in private equity, private credit, and real estate.