Fed funds future implied rate for May 2023 and fed funds target range (upper bound), % Source: Refinitiv, UBS as of November 2022

Major central banks continue to raise policy rates aggressively. The Federal Reserve, European Central Bank, and the Bank of England all raised policy rates by 75 basis points at their latest policy meetings, where comments from central bank officials sparked adjustments in market expectations of a peak in policy rates.

For the US, federal funds futures pricing for May moved up to 5.1% and markets now see rates peaking around June next year to 5.2% (from 5.13%), a new cycle high. However, peak rate expectations for the United Kingdom adjusted lower with the BoE flagging that market expectations had been too high. Accordingly, market pricing has fallen to the 4.5–4.75% region, well below the 6.5% seen a few weeks back. Peak rate expectations for Eurozone also adjusted lower after the ECB meeting, but reversed higher soon after, pointing to a peak rate of 2.8%.

Overall, while peak rate expectations have adjusted, the key message is that policy rates will have to move higher from current levels before major central banks hit pause. Peak policy rate expectations in the US have been a key driver of markets. Recall that before the FOMC meeting, hopes of a slower pace of Fed rate hikes fueled a rally in risk assets, taking the S&P 500 up 9% from its low point in mid-October. However, equities swiftly gave back some gains after the FOMC meeting and Chair Jerome Powell's guidance.

In our view, major central banks are unlikely to end their hiking cycles until 1Q23 and the risk-reward for markets over the next three to six months is unfavorable. For a sustainable equity rally, we believe investors will need to see Fed rate cuts or a trough in economic activity on the horizon. However, these conditions are not yet in place, and we continue to recommend focusing on mitigating near-term downside risks while retaining upside exposure for the medium and long term. Some preferred ideas are:

Focusing on defensive assets when adding exposure. Within equities, we like capital protected strategies, value, and quality income. We like global healthcare, consumer staples, and energy, and have a least preferred stance on growth, industrials, and technology. Weak mega-cap tech earnings release support our least preferred view on technology. By region, we like the cheaper and more value-oriented UK and Australian markets relative to US equities, which have a higher technology and growth exposure and where valuations are higher. Within fixed income, we prefer high-quality and investment grade bonds relative to US high yield. And in currencies, we prefer the safe-haven US dollar and Swiss franc relative to the British pound and euro.

Seeking uncorrelated hedge fund strategies. Hedge funds have been a rare bright spot for investors in 2022, with some strategies, like macro, doing particularly well. With inflation data and central bank policy likely to continue driving a high correlation between equities and bonds in the near term, we recommend investors diversify into less correlated hedge fund strategies to navigate market uncertainty.

Finding value in private markets. Some private market funds are likely to revise down net asset value estimates as a result of the public market contraction this year. But putting fresh capital to work in private markets following declines in public market valuations has historically been a rewarding strategy. In the current environment, we favor value-oriented strategies to build up private market exposure.

Main contributor: Krishna Goradia