Investors should stay defensive if the Fed follows its rhetoric Investors should stay defensive if the Fed follows its rhetoric\images\insights\article\man-work-from-home-office-small.jpg April 28 2022 April 28 2022

Investors should stay defensive if the Fed follows its rhetoric

More rate hikes would favor cash, floating-rate securities and value stocks.

Published April 28 2022
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As our colleague R.J. Gallo notes, the Fed has become so transparent in its intentions that the only surprise would be if there was a surprise when policymakers meet next week. Put another way, we see little reason to expect the policy-setting Federal Open Market Committee to veer off its aggressive tightening path. Chair Powell has said a 50-basis point hike “is on the table” and we would expect him and other voting FOMC members to follow through, not only at the May 3-4 meeting but potentially at subsequent meetings the next two months. This implies a target fed funds range as high as 1.75-2.00% by the end of July.

This anticipated scenario would reinforce what we’ve been recommending investors do ever since it became clear last year that the Fed had fallen far behind the inflation curve: think defensively and reduce risk. In the fixed income arena, that means the shorter the duration, the better, with cash being king. We still favor floating-rate securities that can adjust with rates, and with the economy and profits continuing to grow, see potential value in some portions of the credit universe, including asset-backed securities. Emerging markets are mixed, with the runup in energy and other commodities creating upside in some countries and headwinds in others. Overall, however, our recommended multi-sector positioning continues to underweight bonds relative to stocks.

In the equity markets, a hawkish Fed keeps growth stocks under pressure. To be sure, the year-to-date sell-off in Tech and related growth stocks has been so massive that some may be nearing technical levels that present tactical opportunities. But their valuations continue to get squeezed, mainly from rising rates but also from potentially slower earnings growth on demand-destruction from higher rates and a possible global slowdown on soaring energy and commodity prices. Supply breakdowns due to the Russia-Ukraine war have only made matters worse, with a recession imaginable in Europe. China, the world’s second-largest economy, has its own problems as its zero-Covid policy has spawned aggressive lockdowns amid accelerating cases. While the growth dynamic in the U.S. has heretofore been relatively solid, thus supporting value cyclicals, the negative Q1 GDP flash and the risk posed to growth from rate hikes makes us unlikely to add to those positions. Our highest conviction is an overweight to defensive, dividend-paying value stocks—what we like to call, “the revenge of the boring.” Defensive value names continue to demonstrate pricing power, offer attractive yield, have less duration risk then their bond counterparts and should hold up relatively well if growth slows down.

What if the Fed surprises with a dovish turn, such as a lower-than-expected rate increase and/or guidance that suggests the pace and magnitude of future rate increases will moderate? First, we put a very low probability on such an outcome. Nothing in the data or Fed rhetoric would support it. But, if that scenario were to come to pass, then 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. Of course, the market rarely likes surprises, so judging how it would react to one is fraught with risk. Our base case? No reason to think the Fed will hold its punches, which means after next Wednesday, investors should still want to be defensive. If we’re wrong about the Fed, we’ll share what, if any changes, may be needed.

Tags Monetary Policy . Active Management . Equity . Fixed Income .

Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

Past performance is no guarantee of future results.

Bond prices are sensitive to changes in interest rates, and a rise in interest rates can cause a decline in their prices.

Diversification and asset allocation do not assure a profit nor protect against loss.

Duration is a measure of a security's price sensitivity to changes in interest rates. Securities with longer durations are more sensitive to changes in interest rates than securities of shorter durations.

Gross Domestic Product (GDP) is a broad measure of the economy that measures the retail value of goods and services produced in a country.

Growth stocks are typically more volatile than value stocks.

International investing involves special risks including currency risk, increased volatility, political risks, and differences in auditing and other financial standards. Prices of emerging-market and frontier-market securities can be significantly more volatile than the prices of securities in developed countries, and currency risk and political risks are accentuated in emerging markets.

Stocks are subject to risks and fluctuate in value.

There are no guarantees that dividend-paying stocks will continue to pay dividends.

Value stocks may lag growth stocks in performance, particularly in late stages of a market advance.

Variable and floating-rate loans and securities generally are less sensitive to interest rate changes but may decline in value if their interest rates do not rise as much or as quickly as interest rates in general. Conversely, variable and floating-rate loans and securities generally will not increase in value as much as fixed-rate debt instruments if interest rates decline.

Federated Global Investment Management Corp.