- The Fed is using three monetary tools to combat inflation.
- Markets are now anticipating as many as nine rate hikes.
- We think stocks are still expected to outperform bonds.
As we laid out in last week’s Quarterly Commentary, markets witnessed several major macro events in the first quarter; some expected and some not. These included rapid economic recovery from COVID-19 dislocation and geo-political conflicts (Russia/Ukraine and China). Unfavorable resolution of any or all of these raise the risk of high inflation becoming structural.
Central bankers, governments and markets have a handful of tools at their disposal to try and avoid runaway inflation. Since the economic impact associated with each tool varies, the process will look more like a feedback loop, with each financial constituent interpreting the other’s actions and reacting in real time. This feedback loop is likely to lead to elevated uncertainty, hence the analogy in our 2022 Outlook of market volatility reminiscent of riding a mechanical bull.
In our 2022 Outlook, we listed high inflation, which caused the Fed to tighten faster than expected, as one of the major risks to the market this year. At the time, we believed that inflation would peak in ’22, but had not anticipated war in the region of some of the world’s largest producers of energy and agricultural commodities (see chart, below). Today’s Weekly represents an attempt to update our views regarding inflation and Fed Policy in light of the war in Ukraine, and to provide a series of scenarios of what we think are the likely Fed actions and stock market outcomes.
Dramatic Rise in Commodities Following War in Ukraine
The Fed’s Toolkit to Affect Demand Through Interest Rates:
The Fed has a variety of tools at their disposal to alter the level and path of inflation; three of these were used in the first quarter to combat inflation that remains too high for policymakers, consumers, and investors:
- Adjusting the Short-Term Funds Rate: Fed increased the target range by 0.25%.
- Quantitative Tapering/Tightening: Fed further slowed purchases of bonds and signaled they will be starting to reduce the size of the balance sheet as early as May.
- Signal Future Rate Increases: Fed increased their expectations from three to as many as 8-9 rate hikes in 2022.
Each of these three actions has the goal of curbing inflation, though the Fed must rely on the response of consumers, corporations, and governments for their monetary policy to be successful. For example, when determining production targets, companies must consider the cost of input and the cost of financing. With inflation increasing input costs, incentives must exist to increase the supply of goods, which lowers prices, or for innovative solutions to reduce other costs. The major areas for longer-term innovation appear to be in global shipping/logistics alongside alternative sources of energy. Innovations in either of these areas should reduce the cost of getting goods to consumers, though clean energy will take longer to affect prices, in our view.
The Fed’s guidance has been particularly important to Chairman Powell and has arguably been the most important of the three tools so far. Although they have only increased rates a single time, Chairman Powell's signal regarding future rate hikes has pushed 2-year Treasury note yields to 2.5% over the same period. Thus, the bond market has already largely anticipated the full 2022 guidance. In addition, interest rates of all maturities have risen significantly, causing the worst start to any year for the Bloomberg Global Aggregate Bond Index since its creation in 1990. For consumers, this is evident in 30-year mortgage rates, which have risen from below 4% to above 5%. When combined with high oil prices, this rise in rates reflects a much more restrictive policy than a 0.25% Fed hike would suggest.
Process Over Prediction: Three Scenarios of How This Might Play Out Over 2022
At RiverFront, our portfolio strategy relies less on trying to predict the future, and more on our process of preparing ahead of time to understand possible outcomes and their implications. Our discipline uses historical data combined with experience to determine which scenario the market is trending towards, and then seeks to dynamically adjust portfolio positioning accordingly.
The good news is that for now, longer-term views of inflation reflected in both economist surveys and long-term bond yields are still muted, meaning investors believe supply-side solutions to inflation will alleviate the problem in the long run. We believe there are three outcomes related to inflation; we consider our base case to be the most likely outcome, but we admit that the situation is fluid.
Pessimistic Outcome: Fed stomps the brakes, sending the economy into recession: the Fed comes to believe that the risk of runaway inflation exceeds the risk of wealth destruction due to overseas geopolitical issues and/or COVID-19, and thus applies overly aggressive tightening measures that exceed current market expectations.
Base Outcome: Fed achieves moderation; markets slow but remain positive: the Fed tightens enough to have a positive impact on inflation while not upsetting the economy’s measured economic growth. We think this should be good for stocks.
Optimistic Outcome: Inflation subsides as high prices quell demand and spur supply: the Fed believes that market forces will correct inflation long term, and that their current interest rate targets are either enough or more than needed to combat inflation. This is our most optimistic scenario for stocks. Below is a table of key issues and how they might play out:
In the Pessimistic Case, very few asset classes perform well – commodities and cash will be notable exceptions, much like the most recent quarter, although more protracted. Fixed income will lose its status as a safe asset. Finding uncorrelated assets will be critical. Tactical shifts will be necessary to protect against a recession.
In the Base Case, we believe stock returns will be more muted than what we have come to expect over the last few years, but still better than bonds. We would continue to advocate for strategic purchases of corporate bonds with shorter maturities, bank loans and high-yield bonds, as well as covered call strategies (see Weekly View, 7/19/21, for more information on our views of covered call strategies).
The Optimistic Case is a higher return version of our Base Case. In this scenario, we believe the covered calls and high yield strategies will meaningfully underperform value-oriented equity strategies, although they will perform much better than core fixed income.
The common takeaway across all scenarios is that we think equities should continue to protect portfolios against inflation better than bonds, and that we believe covered calls are likely a great strategy for downside defense and income until interest rates rise. Value-oriented equities should perform well, as should commodity-oriented countries, in our view. We believe Fixed Income strategy should focus on shorter duration credit.
Implications for Different Investor Outcomes
- Accumulate: ‘Accumulate’ investors will face emotional challenges in the pessimistic-case outcome as the value of their portfolios may fall. However, dollar cost averaging through a period of sideways or down markets will be helpful for long term returns and maintaining a long-term outlook will be especially important in our view. The base and optimistic scenarios should work out well for accumulate investors, but they might want to consider raising the equity portions of their portfolios since low interest rates lead to low returns for fixed income and cash long term.
- Sustain: ‘Sustain’ investors will initially struggle with the pessimistic-case outcome because the downside defense characteristics of bonds will not work as expected. We believe these investors should gradually accumulate Treasuries and Fixed Income as yields rise. As yields go up, we believe the protection potential offered by bonds will increase. To the extent that Sustain investors own longer maturity bonds, the rising interest rate environment will be challenging, but the base and optimistic-case outcomes will support the stock portions of their portfolios and high-quality equities should provide growing dividend income, in our view.
- Distribute: While total returns will be lower in the pessimistic case scenario for all the outcomes, ‘distribute’ strategies will be able to re-invest in higher yielding assets in the pessimistic-case scenario. In the base case, using the covered call and high yield strategies might be helpful for income. The optimistic case presents challenges on the income side for distribute investors since yields will likely compress and the portfolio will not produce sufficient income. In this scenario higher stock weightings and systematic withdraws are required to supplement cashflow requirements, in our view.