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Written by: Jacob Johnston | Advisor Asset Management
Equity markets registered better-than-expected, or perhaps, better-than-feared results in the first quarter given the challenging macroeconomic backdrop including the usual suspects of high inflation, additional rate hikes from the Federal Reserve (Fed), slowing economic growth, and the development of instability in the banking sector. The S&P 500 gained 7.5% during the up-and-down period as markets dynamically repriced risk-assets based upon a fluid outlook for Fed policy in the wake of failed regional banks.
The Fed must now contend with a “third mandate” of financial system stability, which has caused a major recalculation of monetary policy. The most likely scenario is the FOMC (Federal Open Market Committee) will hike the Federal Funds Rate an additional 25 basis points to an upper bound of 5.25% at the May meeting. Current probabilities suggest this may be the final rate hike and “terminal rate” for the cycle — much lower than what was previously being priced in just a few weeks ago before the cracks in the bank system emerged. The possibility the Fed will “hike in May and go away,” in addition to the liquidity injection into the bank system, might partly explain the relief rally we have seen in risk assets in recent weeks, particularly long-duration equities like Growth stocks that are relatively more sensitive to changes in interest rates, as the end of rate hikes draws near.
Markets reverted to a familiar playbook that bad news was good news as the strains in the system meant the likelihood of a Fed “pause” was pulled forward. Historically, equity markets have held up relatively well during the phase of a tightening cycle — defined as the time between a final rate hike and a first rate cut. Research from Strategas shows the S&P 500 has gained 5% over 100 trading days during this period, on average.
Source: Strategas | Past performance is not indicative of future results.
We note the Fed has the air cover to pause rate hikes as the Fed Funds rate is now at or above the rate of inflation. Looking at the various metrics, the latest Consumer Price Index (CPI) was 5% year over year in March, while the latest Personal Consumption Expenditure deflator or PCE was 4.6% in February. With Fed Funds at 5–5.25%, they have finally reached the point of positive real yields — seen as a minimum condition for truly restrictive monetary policy to combat inflation.
Ultimately, we believe this restrictive policy stance will have the intended consequence of cooling economic activity, aggravated by tighter credit conditions due to the fallout from the banking crisis, and likely push the economy into recession. This scenario was echoed by the FOMC in the minutes from the March meeting. “Given their assessment of the potential economic effects of the recent banking-sector developments, the staff’s projection at the time of the March meeting included a mild recession starting later this year, with a recovery over the subsequent two years,” per the meeting summary.
Once a recession is upon us, the Fed would be inclined to cut rates, or “pivot.” This is when the equity market tends to be under the most pressure. Research from Strategas confirms that seven out of the last eight tightening cycles, the equity market bottom has occurred after the first rate cut. The S&P 500 Index plumbed the current bear-market lows back in October 2022. It is certainly possible that holds, however, it would be more of the exception, not the rule.
Source: Strategas | Past performance is not indicative of future results.
We have stated for about two years now that it is a macro-driven market, and the Fed is in the driver’s seat. While it might seem a little “inside baseball” to parse between a Fed pause and a Fed pivot, historically, they have led to different equity market environments.
We want to avoid letting the relief rally we have seen following regional bank failures fool us into thinking the coast is clear.
In fact, we would use it as an opportunity to rebalance or reallocate toward investment solutions that we believe could be better positioned for the final innings of the tightening cycle. This would include higher quality factors such as profitability and free cash flow, as well as an emphasis on income generation that can mitigate volatility and supplement total returns.
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