Every time the Fed meets, announcements are made about how it views the condition of the US economy and its upcoming challenges.
Fed members have long believed that the extraordinary “easy money” policies that bolstered markets and supported the economy through the COVID-19 pandemic would end and that short-term interest rates would rise in 2022. However, in Dec 2021, they discussed reducing the Fed’s balance sheet in addition to rate hikes.
Citi analysts see an inherent contradiction in the Fed’s dual policy views and choices. Using bond runoffs as a source of economic and inflation restraint would presumably limit the absolute number of rate hikes needed, thus resulting in reductions in yields across the curve. Yet, the Fed would also raise rates at the same time.
Using multiple policy tools to tighten for just the second time in history adds to macro policy uncertainty and poses some risks with the nascent recovery. Compared to its recent caution and concern for the growth outlook, the Fed now appears overconfident.
Citi’s focus remains on the economy itself and corporate profits, in particular. Changes in bond purchases by the Fed may influence the economy and help explain returns, but rising profits in the last decade meant positive returns even when the Fed did not provide support. Citi analysts think the same may be true going forward. However, the overall profit gains of 2022-2023 may be significantly lower than 2021.
Citi analysts reiterate our strategy of favoring higher quality, larger and more profitable firms in equity holdings, preferably in less cyclical industries. Citi analysts do not believe that all growth stocks face the same recovery prospects. The current market environment has led to significant underperformance of the least profitable and most speculative companies, some of which may never deliver on the market’s high hopes for their future earnings.
Areas like payments – a subsegment of fintech – as well as certain firms within Citi’s clean energy and cyber security themes have fallen to much more reasonable valuations on a growth-adjusted basis.
Investors may face short-term risks while the Fed calibrates its policies for the benefit of the economy at large. That said, Citi analysts do not fear that the US central bank has already undermined the recovery. Economic progress and positive returns have historically coexisted well into tightening cycles.