Measured Fed tightening should not derail markets

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Risk sentiment improved this week ahead of the Federal Reserve’s interest rate decision due today and megacap tech companies’ September-quarter results. Investors found solace in recent data confirming the strength of underlying AI demand. The S&P 500 has risen 1.3% over the past two sessions, while the 10-year US Treasury yield edged up to just above 5%.

The Fed is widely expected to keep rates unchanged at 3.75-4% today, following recent comments from several officials that supported a gradual approach. Still, investors will watch how Chair Kevin Warsh explains the central bank’s rationale after data for September showed a reacceleration in inflation. Current fed funds futures indicate three additional 25-basis-point rate hikes over the next 12 months.

Our view is that current market pricing of Fed tightening is too hawkish, and the backdrop for equities, fixed income, and gold remains constructive.

Robust earnings growth should outweigh monetary tightening for equities. The upcoming tech earnings should provide more evidence on the sustainability and monetization of AI demand, while recent results have been in line with our view that AI should continue to be a key driver of profit growth. Additionally, we expect cyclical segments of the market to see robust earnings growth as manufacturing activity remains in expansion, while healthy aggregate consumption should offer another pillar of support. We therefore expect the S&P 500 to continue to move higher over the next six to 12 months as the Fed tightens modestly. In fact, the average gain in the S&P 500 one year after the first Fed hike was 10.8% over the past 16 hiking cycles since 1954.

Quality bonds offer appealing income and diversification benefits. US Treasury yields may continue to face upward pressure amid uncertain geopolitical situations, persistent inflation, additional debt supply from hyperscalers, and ongoing fiscal concerns. But we think what’s more important for investors is that current yields offer sufficient income to compensate for the risk of further volatility. Starting yields have historically been a good indicator of subsequent total returns, and we think a potential Fed repricing could lead to a decline in Treasury yields, leaving scope for capital gains in bonds. The recent performance of Treasuries also suggests that quality fixed income is being perceived as a “haven asset” again, offering diversification and stability in a portfolio.

Gold remains a strategic portfolio diversifier amid structural support. While gold exchange-traded funds (ETFs) recorded net outflows last week, longer-term fundamentals for bullion remain solid, and we think structural demand should support higher prices. Central bank purchases continue to be strong, Chinese buying is robust, and concerns about rising public debt levels and debt-servicing costs have not abated. With structural dip buyers likely establishing a floor around the current USD 4,000/oz level, we think gold prices have limited downside from here and maintain our view that further pullbacks offer opportunities to add exposure.

So, while more Fed hikes remain in store in the coming months, we think the current backdrop remains favorable. We do not believe a measured tightening cycle will derail the US economy, and investors should maintain diversified equity exposure and use the rise in yields to add selectively to quality bonds. We also believe gold remains an effective portfolio diversifier.