The Late, Late, Late Fed Show

Taken at its word, the Fed will begin “rapid” Quantitative Tightening roughly two months after halting Quantitative Easing. Its projected short-term interest rate increases in the year ahead will roughly match the largest for any annual period in history. The Fed has positioned policy to be pro-cyclical rather than countercyclical, likely adding to financial market and economic volatility.

Lagging indicators such as employment and inventory restocking provide “inertia” for economic growth to continue this year. However, a demand slowdown is inevitable.

Therefore, Citi analysts have further shifted their asset allocation to better absorb greater market volatility and less robust economic growth following a strong recovery.

When growth becomes harder to achieve, it becomes more valuable in portfolios

• The new supply shortages are not the sole source of continued high inflation – but they will extend the shock. Compared to CIO’s view last year that US Consumer Price Inflation would end 2022 at a year/year pace near 3%, Citi now sees it near 6.5% before falling to about 3.5% over the course of 2023. This assumes CPI inflation peaks in the near-term at about 8.5%. In other words, CIO believes the most rapid price rise in consumer prices has already occurred. The absence of fiscal support this year amid high inflation is now forcing consumer demand to drop. The US Federal Reserve cut its median real economic growth view by 1.2 percentage points for 2022, and similarly, CIO cut its US growth forecast by a more severe 1.6 percentage points to 1.9% from 3.5%.

• In our CIO's view, one way to play the equity market in the current environment is via defensive, quality growth. 
  • CIO’s base case RESILIENT scenario assumes slowing economic growth but not a recession. It’s important to find opportunities that will provide sustainable, positive returns even in a decelerating growth environment. 
  • CIO’s expectation for government bond yields to peak this year is potentially supportive for those sectors most reliant on a low discount rate to justify their valuations. It does not, however, support firms that need to borrow to survive. 
  • As an exception to CIO’s negative view on many cyclical sectors, medium-term disruptions to commodity supply warrant bolstered allocations to energy and natural resources producers. 
• When growth becomes harder to achieve, it becomes more valuable in portfolios. Citi believes that in a slowing economic environment, the value of companies with dependable, visible growth increases. This is why Citi is looking at defensives over cyclicals. History also supports a bias toward high-quality growth, as mid-cycle slowdowns over the past three decades tended to see large-cap growth stocks outperform other equity size and style factors on average.
• What’s more, while never cheaper than their value peers, growth equities have already experienced a significant de-rating amid the “rate shock” year-to-date. This means that growth stocks can stage a comeback once rates have peaked.