Fed pause amidst economic uncertainty?
The Federal Reserve (Fed) hiked interest rates 25 basis points at its May policy meeting, taking the upper end of its target to 5.25%. The Fed also indicated that it may pause rate hikes as it observes how the economy is reacting to its ongoing policy moves. We agree with the Fed that the outlook is uncertain: weak manufacturing, regional bank turmoil and declining corporate profitability are coinciding with a resilient labor market and consumer spending.
Our view is that there is a high probability that US growth will continue to weaken and enter recession later this year. We continue to rely on leading economic indicators, where the growth rate is at a negative level that has historically coincided with US recessions.
Exhibit 1: Leading Economic Indicators at Recessionary Levels (right click to enlarge image)
Multi-asset implications of a Fed pause
Despite the economic uncertainty, a natural question arises: Can a Fed pause propel risk assets higher? Looking back on 2022, it’s fair to say that increasingly restrictive monetary policy caused much of the weak asset performance. Shouldn’t risky assets rally if “peak Fed” is in place?
Historically, we have seen a rally across asset classes following a peak in the fed funds rate. Many assets—Treasuries, corporate credit and equities—have done well. Notably, equities, which should outperform less risky assets over time, perform slightly worse than both.
Exhibit 2: Most Assets Have Rallied Around Peak Fed Funds Rate (right click to enlarge image)
Digging further, our hunch is that not all Fed pauses are created equal. Some occur with varying levels of growth and inflation and at different stages of the business cycle. We focus on the business cycle and use the yield curve as a method to further classify Fed pauses. We also look at Fed pauses that were eventually followed by recessions in the next year. What we find confirms our hunch—the later we are in the business cycle, as highlighted by an inverted yield curve, the worse equity performance has been. If a recession eventually follows a Fed pause, equity performance tends to be outright negative.
Exhibit 3: Peak Fed Funds Rates Occur in Varying Macro Environments (right click to enlarge image)
Exhibit 4: Business Cycle Factors Can Overwhelm Fed Policy (right click to enlarge image)
Portfolio implications
We often debate whether growth or policy is a more important factor for risky asset performance. Over the past few years, it has felt like interest rates and Fed policy have been powerful drivers. The analysis above suggests that a Fed pause will not save the day for risky assets like equities, and that it is more prudent to be allocated to safer assets, like Treasuries and cash. We pay careful consideration to where we are in the business cycle and when our forecast of recession risk is high; these considerations further the case against equities. If the United States enters a recession, weak growth is likely to trump any policy easing. We remain positioned defensively in our portfolios, favoring assets like Treasuries and cash over equities. Within equities and credit, we currently prefer higher-quality assets.
WHAT ARE THE RISKS?
All investments involve risks, including the possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. The positioning of a specific portfolio may differ from the information presented herein due to various factors, including, but not limited to, allocations from the core portfolio and specific investment objectives, guidelines, strategy and restrictions of a portfolio.
Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions.
Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Investments in lower-rated bonds include higher risk of default and loss of principal. Changes in the credit rating of a bond, or in the credit rating or financial strength of a bond’s issuer, insurer or guarantor, may affect the bond’s value. In general, an investor is paid a higher yield to assume a greater degree of credit risk. The risks associated with higher-yielding, lower-rated debt securities include higher risk of default and loss of principal. Investments in foreign securities involve special risks including currency fluctuations, economic instability and political developments.
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