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Weekly Market Analysis: What Happens After the Fed Reaches Peak Rates?
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One more rate hike?
The end of the US rate hiking cycle appears imminent. At its early May meeting, the Fed is expected to raise rates by 25 basis points even as the Index of Leading Economic Indicators has fallen nearly 8% over the past 12 months. The Fed is tightening even as the US broad money supply is contracting for the first time since the 1940s. The Fed is determined to blunt the post-Covid recovery and secure a period of disinflation ahead.
The end of dollar dominance
The US dollar has had three secular bull markets over the past 50 years and is likely beginning a third secular bear market. And if the Fed maintains its hawkish strategy, it only increases the probability it will reverse course more forcefully in the future. The US has the most cyclical labor market of major developed market economies. For this and other reasons, the Fed makes the most extreme monetary policy adjustments among developed market central banks.
Where foreign currencies may rise
The ECB and other central banks will likely withhold from rate cuts deep into 2024 while the Fed eases, in CIO’s view. After more than a decade of US dollar appreciation and the extreme USD spike of 2022, this should contribute to ongoing US exchange rate weakening.
Summary
While a mild recession for the US is CIO’s base case, some unpredictable, negative tail risks are at play, including Congressional negotiations over the US debt ceiling. CIO thinks direct hedging of portfolio risks may be appropriate for suitable investors concerned with near-term performance risks. This is particularly the case now that many defensive investments have arguably become “crowded trades.” A strong decade of US dollar outperformance in currency markets is ending, suggesting potential stronger returns for portfolios via global portfolio diversification. While CIO doesn’t expect this will necessarily help portfolios in the few key months ahead, there’s a potential chance it will support investor returns measured in USD over coming years.
Portfolio considerations
In the current environment, less cyclical growth sectors are better positioned for continued potential outperformance. These include areas of the software space which tend to deliver more stable profits, as well as firms tied to government subsidies and spending like electric-vehicle-battery producers and semiconductor equipment firms.
Source: Haver Analytics as of April 22, 203. Indexes are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. All forecasts are expressions of opinion and are subject to change without notice and are not intended to be a guarantee of future events. Past performance is no guarantee of future results. Real results will vary.
One more rate hike?
The US central bank is continuing to tighten even as the US broad money supply is contracting for the first time since the late 1940s. The Fed is determined to blunt the post-Covid recovery and secure a period of disinflation ahead. With the release of bank earnings this week, the likelihood that banks will lend less and raise costs for borrowers has risen materially. Many depositors are thinking more deeply about T-Bills and money market funds due to the uncertainties around bank balance sheets. Over the coming weeks, the Fed’s senior loan officer survey for the second quarter will illuminate any further restraint banks are placing on lending looking forward. Remember that data for the past three quarters already suggested a contraction prior to the Silicon Valley Bank surprise. The US Congress has legislated debt ceiling increases to ratify its spending and borrowing roughly annually for more than a century now. Will partisan conflict in the coming two months lead to unusually severe brinksmanship and severe emergency spending cuts (in order to avoid a US debt default)? Probably not, but no one can make any promises. As such, CIO thinks direct hedging of portfolio risks may be appropriate for suitable investors concerned with near-term risks. This is particularly the case now that many defensive investments have arguably become “crowded trades.” Ironically, US equities are priced as though a near-term recovery is already here even as various impacts of policy tightening are still rippling through the economy.
The end of dollar dominance
In 2022, the Fed’s unusually abrupt tightening cycle and the Russian energy shock sank many currencies to record lows against the US dollar. But looking more broadly, the US exchange rate had already enjoyed more than a decade of net gains previously. Powered by the US dollar rally, US equities rose to as high as 62% of global market cap last year on an unusually high relative valuation. Though CIO has identified some exceptional technological opportunities previously, “exceptionalism” is already priced into the US exchange rate. The strong decade of outperformance behind us now suggests a return to value for global diversification. CIO doesn’t know if this greater diversification will help portfolios in the few key months ahead. Yet with today’s much lower valuations for non-US shares, some positive growth developments away from the US, and a pending turn in an aggressive Fed tightening cycle, there is a chance it could potentially support investor returns measured in USD over the coming year. In fact, positive currency-linked returns from global diversification may likely persist much longer.
Where foreign currencies may rise
CIO believes the ECB and other central banks will likely withhold from rate cuts deep into 2024 while the Fed eases. After more than a decade of US dollar appreciation and the extreme USD spike of 2022, this should contribute to ongoing US exchange rate weakening. CIO would also expect some emerging markets, including China and Brazil, to ease monetary policy. Given the backdrop of US rate cuts in the coming year, this should have positive consequences for local markets. For Europe, the recent key pain point was the surge in natural gas import costs last autumn as Russian supplies were cut off. This generated a terms of trade shock and a brief economic contraction. While Europe will not become a growth paradise, CIO expects upward revisions to consensus views of European growth in the coming year just as CIO does for China. The US is unlikely to benefit much from these modestly positive external developments until US labor markets weaken and the Fed eases.
Portfolio considerations
The bear market isn’t over yet, in CIO’s view, but there are potential opportunities to shift portfolios to take advantage of longer-term value. Investors shifted toward defensive sector and asset class positions already over the past year. This leaves less opportunity for core defensive strategies to outperform. Corporate profit estimates are at risk to some degree everywhere. Yet it makes more sense to face these risks at a 12.9x estimated profits outside the US vs 19.3x for US shares. US markets have sharply outperformed both during and post-Covid, raising performance risk over the coming year. In the year to date, CIO’s overweight position in large cap US equities has outperformed an underweight in small caps by roughly 700 basis points. CIO is not yet ready to give up this component of our defensive position because small and midcap shares tend to be strong outperformers only once a decisive recovery cycle has begun. If there’s a midyear correction in global equities, it might be reasonable timing to raise CIO’s holdings.
