Your browser does not support JavaScript! Pls enable JavaScript and try again.

Economy/Politics | Equities

Taming Inflation Is Priority One: What This Means for Markets and Investors

Posted on

If you wanted Federal Reserve Chairman Jerome Powell to provide guidance that the US economy would remain strong in 2023 and the Fed would be careful to pause and protect it, the Chairman’s Jackson Hole speech last week was disappointing. Powell held out hope for the period beyond what will be a near-term difficult phase for the economy.

He noted that long-term inflation expectations have remained low even as the Fed has tightened. This means the conditions prior to the early 1980s – a 15-year period of accelerating inflation followed by two deep recessions – are unlikely to be repeated.

But how much tightening will it take for inflation to sufficiently tamed? Powell said reducing inflation is likely to require a sustained period of below-trend growth. In the CIO’s view, this is set to occur in 2023 on the Fed’s rate hikes of 2022 and concurrent action to reduce lending to the bond market.

Powell said the Fed’s actions would not be pain-free.

“Reducing inflation is likely to require a sustained period of below-trend growth. Moreover, there will very likely be some softening of labor market conditions. While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain,” he said in his comments at the Fed’s Jackson Hole summit.

CIO thinks that only a decisive weakening in employment will cause the Fed to retrench. And as discussed previously, US labor markets have provided no lead time before the start of economic contractions. Forward-looking financial conditions – measured with both bank lending standards and US equities – already suggest a contraction in employment will come in the year ahead.

WMA Graphic

In CIO’s view, the Fed’s moves to drive up asset prices and employment – and then push both down – is sub-optimal policy. That said, Citi believes its investment strategy is the right one for this environment:

1) CIO is underweight global equities, with Europe particularly hard hit by US monetary tightening from the  West, and energy supplies tightening from the East.

2) CIO would be cautious on cyclicals generally after rate impact hit growth shares more sharply in 1H 2022. This includes US cyclicals, where S&P 500 EPS could fall nearly 10% in 2023. CIO also prefers to avoid leveraged and less-well-capitalized US small-cap shares and emphasize “long-term leaders” in US large caps.

3) High quality US bonds remain attractive. Forward-looking yields have already risen to reflect Fed policy and there may be another “U-turn” coming in mid-2023 if employment falls more quickly than anticipated.

4) CIO believes quality matters in both stocks and bonds. Coupon payments from investment-grade issuers in both asset classes are reliable sources of return.

5) CIO is assessing potential opportunities in higher risk investments every day. There are long-lasting opportunities in sectors such as healthcare, innovative energy and software. Greater opportunities to invest tactically in riskier equities will arise when the economy is again nearing an early stage of recovery.               

Note: Past performance is no guarantee of future results. Real results may vary.

Related Articles