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Multi-Asset Strategist Adam Berger and US Macro Strategist Juhi Dhawan spoke recently about Federal Reserve rate hikes, the risk of recession, the outlook for corporate profits, and the implications for asset allocators.
Adam: The Fed is driving an enormous amount of market volatility and investor uncertainty. What will it take to bring about an end to the central bank’s policy tightening?
Juhi: The Fed has two mandates: low unemployment and low inflation. The latter is obviously the primary focus right now. The Fed wants to re-anchor inflation expectations and is paying close attention to two variables, which are highlighted in Figure 1. The top chart shows the market’s inflation expectation, and it is higher than it has been in years, despite having dipped a bit recently. The bottom chart shows the consumer’s inflation expectation, which is a bit more anchored and therefore more encouraging from the Fed’s standpoint. To gain confidence that inflation is truly anchored and be willing to end the tightening cycle, the Fed will have to see tangible signs that inflation is on a sustainable downward path toward its 2% target. It will, of course, also be paying attention to the tightness in the labor market and whether that eases somewhat from here.
Adam: Can the Fed bring inflation down to a comfortable level without sparking a recession?
Juhi: That’s a difficult question to answer. When inflation is this elevated, there are no guarantees that the Fed can achieve a soft landing for the economy. The Fed has effectively admitted that, acknowledging that their tools are blunt and take time to work. While I realize it may not provide much comfort to allocators trying to plan for what comes next, I do believe the Fed has a shot at, if not a soft landing, at least a soft-ish landing. Again, I would point to the bottom chart in Figure 1 as an indication that there is at least some possibility that the Fed is able to anchor inflation expectations and pause the rate tightening in time to mitigate the scale of damage to the economy.
Adam: Given the economic backdrop, what is your outlook for corporate profits?
Juhi: Coming off a record year for corporate profits, which were up some 70% in 2021, I expected this to be a year of normalization, with profit growth slowing significantly. So far, that has been the case and I expect very modest to moderate gains in profitability from here.
An important element of the profit outlook is what happens with the US dollar. Companies in the S&P 500 take in about 40% of their earnings from overseas markets. If the dollar remains as strong as it has been recently, that makes it more challenging for companies to maximize those overseas profits. They may need a little help from other parts of the world to drive the dollar lower, not just from the Fed.
In terms of quantifying a possible earnings recession, we have seen profits decline 5% – 15% in previous inflationary environments.
Adam: Taking into account your views on Fed policy, recession risk, and corporate earnings, what are the implications for US stocks and bonds?
Juhi: Profits are the single biggest driver of the S&P 500 over time, and Fed policy is the second biggest driver, given its impact on multiples. So, more modest profits and a Fed tightening cycle suggest this is a time to scale back stock return expectations, especially compared with recent years. I would expect lower returns not just this year, but potentially over the next few years.
The bond market, of course, had a very difficult first half of the year in terms of returns. For bond investors to believe that returns can rebound, I think they will need to see the Fed successfully anchor inflation expectations and get the economy back on a path where the inflation rate can normalize.
Adam: Let me wrap up by sharing a few of my own thoughts on the US economy, markets, and potential next steps for asset allocators.
First, a policy tightening backdrop has historically not been good for stocks. We have already seen this play out year to date, and caution and care remain warranted moving forward. While the Fed may be able to engineer a soft-ish landing, as Juhi noted, this is never an easy task, and it is complicated this cycle by two destabilizing forces: the magnitude of the fiscal and monetary response to COVID and the Russia/Ukraine conflict. In addition, inflation risks remain skewed to the upside, which could keep the Fed on the defensive longer. However, looking at the bottom chart in Figure 1, it is reasonable to ask whether the market has been too quick to rule out the idea that some of the inflation was driven by COVID supply shocks and Ukraine-driven energy spikes, both of which may wane regardless of Fed policy.
As for next steps, I think allocators should consider the following:
Stress test portfolios for recession. This may include thinking about stock/bond correlations and gauging how a portfolio could be affected if stocks continue to sell off and bonds don’t provide the hedging benefits they have in the past.
I say “stress test” rather than reallocate, because I think most asset owners will be better served by managing their portfolios through a recession rather than trying to massively derisk and sidestep a recession. Allocators should be realistic about their ability to time the market, which requires being right about when to get out of the market and when to get back in. As we’ve seen historically, there can be shallow recessions that result in unexpectedly long bear markets, and vice versa — adding to the timing challenge.
Allocating to defensive equities and alternatives. Given that fixed income may be less effective at offsetting an equity market sell-off going forward, investors may want to consider the role alternative investments, including hedge funds, could play in complementing the returns of fixed income and potentially offering protection in a drawdown, as many have this year. Beyond fixed income, this may be a moment to think about making equity portfolios more resilient via defensive equity strategies, including “compounders” — equity strategies focused on companies with high and stable free-cash-flow yield and the potential to grow modestly but steadily over time.
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