The Fed May Act Rationally to Normalize Policies

It was a tumultuous week in markets, with investors on edge, worrying how far central banks may go to stamp out inflation. Since January 3, the S&P 500 index has sunk 8% while the Nasdaq is down 12%.

The Fed’s signaling its intention to raise interest rates and reduce its balance sheet simultaneously has already resulted in a true, effective tightening of monetary policy in early 2022.

Citi analysts believe this isn’t a typical inflationary period. The torrent of monetary, fiscal stimulus and COVID-19 driven supply distortions over the past two years caused major supply-demand imbalances and labor market distortions.

Citi analysts also believe policymakers have little choice but to accept the one-off rise in consumer prices that resulted from COVID-19 stimulus and temporary – albeit lingering – supply/demand imbalances. And in Citi’s view, policymakers may understand that hurting consumer demand may not solve current challenges.

Portfolio Considerations

The early 2022 reckoning in stock markets has been concentrated in equities with the highest valuations. As such, Citi analysts prefer to limit allocations in US growth equities to established, profitable firms. Our largest allocation and largest sector overweights are global dividend growth equities and healthcare, respectively.

However, “interest rate victims” in the present selloff include the strongest technological franchises in payments, fintech and cybersecurity. Citi analysts see the selloffs in select equities as a buying opportunity for long-term investors.

While far from a “good yield,” the rise in rates means that investment grade fixed income securities are becoming a more compelling low-risk asset in portfolio construction.

For the immediate outlook, Citi analysts are looking outside the US: the valuation for most of the world’s individual shares look nothing like the highest fliers on the Nasdaq. Non-US shares across all regions trade at a mere 13X expected 2022 EPS.

In the end, Citi analysts expect that the Fed may act rationally to normalize its policies without crushing a nascent recovery. By announcing its intention to use both rate hikes and balance sheet reductions to tame inflation, it may have already achieved some of its objectives in spite of its limited ability to tame COVID-19 driven inflation.