Defense still rules in this market

The Fed “put” has been around so long, it’s hard to let go. That was evident in late May, when stocks rallied strongly off their lows for the year on reports a non-voting Fed member thought a September pause may be warranted. We were skeptical of the rally, as we feared that, once again, market participants had become complacent to the risks posed by inflation and a hawkish Fed. Events—and comments from voting members—since have reinforced our skepticism. With “peak” inflation proving elusive—this morning’s CPI report for May came in at a fresh 40-year high, blowing past consensus expectations—half-point rate hikes are all but baked in at Federal Open Market Committee meetings next week and in late July. Fed futures are pricing in 200 more basis points of hikes through the year, making a third half-point increase possible as soon as September and lifting the fed funds target range to 3.00% by year-end. To badly paraphrase Prince, this is what it looks like when Fed doves cry.

Against this backdrop, investors should continue to play defense, with a hard tilt toward shorter duration and higher quality assets on the fixed income and equity side. In fixed income, this means keeping a preference for cash and short-term credit instruments, and an underweight to longer-duration government and credit bonds. Within equities, stay underweight growth and overweight value, with a particular preference for defensive, dividend-paying stocks. Use rallies to further reduce exposure to longer-duration assets, and meaningful pullbacks to add to more defensive assets. While the run-up in energy and other commodities has created upside in some emerging markets, it’s stirred headwinds in others. So, caution is merited. Overall, our recommended multi-asset positioning continues to underweight bonds relative to stocks, with the understanding a hard landing could create potential opportunities in high-quality, longer-duration assets at some point in the future. For now, though, it’s way too soon to make that call.

If the Fed were to surprise—and there’s virtually nothing to suggest it will, particularly after May’s CPI report—and indicate a pause may be in order come fall, it likely would take some pressure off yields. That would favor growth stocks, make for a longer up-cycle in cyclical stocks and aid longer duration fixed-income assets. Shorter-duration and floating-rate securities would be the ones under pressure. Given the data of late, none of which exhibits cracks in the “sticky” inflation narrative, we just don’t see that happening. Nothing we have seen would suggest the Fed will hold its punches, which means after next Wednesday, investors should remain defensive.