Markets Hit the Rate Reset Button
Here's what faster-than-expected Fed rate hikes may mean for investors.
Last week's release of Federal Open Market Committee (FOMC) minutes threw cold water on any remaining hopes that the Fed will take it slow during this upcoming rate cycle. The minutes, from the FOMC's meeting in mid-December of last year, indicated that the committee may be considering faster rate increases than previously anticipated, and prompted a "rate reset" in the markets last week that was fast and furious.
Not only did nominal rates reach new recent highs (with yields on the 10-year Treasury touching 1.80%), but real rates finally declared themselves by breaking out of their long-term range.
I had a hunch that this is how the impasse in real rates would be resolved. After all, part of the objective of a Fed tightening cycle is to slow down an overheating economy, which generally involves higher (or less negative) real rates. This may now be happening.
Rate reset hitting small caps and crypto
It wasn't just rates that thundered last week. While the S&P 500® remains within spitting distance of its latest all-time highs, there's been carnage in stocks and assets that had been flying high on ample liquidity—including small caps, so-called "meme stocks," and crypto. The liquidity tide is going out, and it is not taking any prisoners.
How high could rates go?
The Fed's tightening cycle is just getting started, and financial conditions remain near their loosest ever. So any talk of a dovish Fed pivot seems very premature. The market is currently pricing in 6 rate hikes for 2022 and 2023. In my view, a lot more needs to happen to stocks, rates, spreads, and the dollar to throw the Fed off that course.
I think that a reasonable base case could be that the federal funds rate reaches 2% in 2024. From there, it may be a question of whether the Fed returns to neutral (meaning, the rate at which it is neither accommodative nor restrictive) or keeps going all the way to restrictive. Even if inflation returns to around 3%, an increase to a 2% nominal federal funds rate would still leave the Fed very accommodative in real terms.
The other side of the coin is that the economy has become so acclimated to low rates, that perhaps a return to 2% is all that the Fed can do, or needs to do. The above chart shows that in the past, the monetary policy pendulum would swing all the way from 2 to 3 percentage points below to 2 to 3 percentage points above the natural rate of interest, or R* (which represents the theoretical real interest rate that should prevail when the economy is running at full strength and inflation is stable). That was the full Fed cycle. But in 2018 it only made it back to neutral, before the markets started to seize up. So maybe neutral is the new restrictive.
Outlook for equities: Potential opportunities for stockpickers
For equities, the next year or so is likely to be a lot less straight up than 2021. The Fed is now actively taking the liquidity punchbowl away. And the earnings cycle is transitioning from acceleration to deceleration. That's not bearish by any means, but it does indicate we may be entering a new phase of the market cycle.
A growth-to-value rotation seems plausible in the coming months. The financial and energy sectors, for example, tend to be positively correlated to rates, and so may see a lift from rising rates.
A rotation could bode well for market breadth (which measures how many individual stocks are gaining rather than declining). The chart below shows that the percentage of S&P 500 stocks outperforming the index has fallen from 60% to 45% in recent months. After a frustrating year for some active managers, perhaps 2022 will be better.
One contrarian opportunity within the stock market could be utilities. While they are negatively correlated to changes in rates (with rising rates typically pressuring the stocks), they could offer an opportunity for both yield and stability once we inevitably reach the later stages of this earnings cycle. The last time utilities were this oversold against the broader market was December 1999.
Emerging markets due for a reversal?
Finally, I still like emerging markets for 2022. Emerging-market equities were a big disappointment in 2021, despite easy financial conditions and soaring commodity prices (usually both reliable drivers). But they may be due for a reversal of sorts. China's credit impulse (which measures credit growth as a percent of GDP) may have bottomed out and be poised to recover, which should bode well for relative earnings growth (which typically lags 6 months behind credit growth).