What Fed Tightening Means for Portfolios

The Federal Reserve has changed its minds. The Fed is speeding its “exit from easing” and presenting a favorable gradual “return to normal” scenario as likely.

The Fed’s actions and forecasts are most consistent with a view that the pandemic and the government’s discrete policy response may not engender a long-lasting rise in inflation.

Monthly gains in goods spending have been diminishing ever since the last wave of stimulus in the first quarter of 2021. In Citi’s view, the pace of demand is starting to fall back in line with gains in real personal incomes with no new mass stimulus to come. With slower consumer spending coupled with growing imports and production, supply and demand imbalances may gradually close.

The absence of market pressure in long-term yields in the face of the Fed’s tightening campaign is notable. Powell remarked that in a low global yield environment, investors are able to take advantage of premium US yields. Combined with expected growth in corporate earnings, this is constructive for further potential gains in equity prices and negative real returns in many bonds.

In the coming months, day-to-day swings in the performance of negatively correlated equity sectors may be extreme. Yet, there are possible clear winners in the environment that Citi analysts see unfolding. Certain defensive sectors, like Consumer Staples, may benefit from moderating input cost and supply chain normalization. Some “Unstoppable Trends” like Fintech and Health Care can be beneficiaries.

The onset of the next phase of the economic cycle – a period of expansion that needs to weather monetary tightening – suggests a shift to quality, income generating assets. While Citi analysts are fully aware of the value of future growth and innovation, an environment of “scarce financing” may mean success may come less easy for speculative ventures. Citi analysts believe this is driving the current market dynamic, where dividend growth shares are outperforming, and profitless firms are falling.

Citi’s portfolio asset allocation has shifted to a more defensive posture without retreating into the “fear trade” of owning negative real-yield bonds or cash. We want to retain exposure to long-term growth assets that are changing the world economy, tactically over-weighting “defensive growth and income” assets we find in dividend growth shares across the globe.