Don't Fight the Fed

expand iconUtpal Diwanexpand iconexpand icon10 JAN 2022
Rising rates, peaking inflation and the quantitative tightening.
TABLE OF CONTENTS

State of the Market

Risks

War Against Inflation

To Hike or Not to Hike ..

Incremental Hedging and Sector Re-allocations

Style Factor Re-Alignment

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The Fed tightening is playing out, as liquidity removal since the start of the year has been driven by the bond market sell-off and equity weakness. Just because the Nasdaq is off 12% from the Dec highs, it doesn't mean that the tightening is close to being done.

State of the Market

There are plenty of risks in the global economy, including geo-political events related to Russia (Ukraine invasion) or China (Taiwan risk), a renewed trade war, and so on. However, in our view, the biggest near-term risk is right in front of us. The U.S. Fed is frighteningly behind the curve and has to get serious about fighting inflation.

With economic growth beginning to slow stateside, Fed Chair Jerome Powell is now in a position to repeat the blunder he made in the fourth quarter of 2018. Deceleration in economic growth looms with the Empire manufacturing index printing -0.7 versus an estimated +25.

Risks

That said, there is a trifecta of risks that the market has recently started discounting.

i) The US is facing the highest inflation since 1982 and there is compelling evidence that a good chunk of it will persist.

ii) The Fed has never responded this slowly to an emerging inflation risk and even today is signaling a benign hiking cycle.

iii) If they are wrong, and inflation settles closer to 3% than 2%, it is bad news for both stocks and bonds.

War Against Inflation

It has been a long time since markets have had to deal with a Fed waging war on inflation. However, something doesn't compute. A central bank that signals that it will taper a bit faster and could end its zero-rate policy six months from now is hardly fighting inflation. The median Fed forecast assumes inflation tumbles from 5.3% in 2021 to 2.1% by the end of 2024. Hence the Fed does not plan to return to its 2.5% estimate of the neutral rate nominal funds rate any time in its forecast horizon.

To Hike or Not to Hike ..

.. is the million dollar question. Will the Fed hike rates in March? Will they be able to cut all 4 times? As humble students of history, we know that tightening into a slowdown doesn't go so well. The market might have already discounted this given the correction we have seen, but navigating this macro environment requires laser focus.

Incremental Hedging and Sector Re-allocations

Taking cues from what we see above, we have added incremental hedges to each of our portfolio, including short positions in the S&P500, small and mid cap technology stocks and a synthetic volatility hedge. We have also rejigged our barbell and have moved the fulcrum away from high growth sectors like technology into lower growth, cash flow generating sectors like healthcare. In the long-run, we are firm believers that technology is a deflationary force and those stocks will be rewarded, so our trim does not imply we are less bullish on the prospects of these growth stocks. It just means that we are maneuvering our client's blocks to adjust to the macroeconomic forces at play.

Style Factor Re-Alignment

We are reducing our exposures to momentum, leverage and growth and adding to our exposures on value, dividend yield and size.

Stay safe, stay humble, stay nimble!

Utpal Diwan

Utpal Diwan

Author

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