Where There Are Lemons, There Is an Opportunity to Make Lemonade
The Fed raised interest rates by +0.75% last week at its September FOMC meeting. It was the third consecutive +0.75% rate increase, setting the new target range at 3% to 3.25%. For reference, the federal funds rate target range was 0.25% to 0.50% leading up to the first interest rate hike in mid-March. The decision to proceed with another large rate hike was driven by persistent inflation pressures in recent CPI and wage reports and the Fed's determination to bring inflation down to 2%. The Fed's actions this week shouldn't come as a surprise after the August and September CPI reports.
The September dot plot was significantly more hawkish than the last update. Back in June, Fed officials forecasted the federal funds rate would reach 3.4% by the end of 2022 and 3.8% by the end of 2023 before declining to 3.4% by the end of 2024. With the September release, those estimates increased to 4.4% by the end of 2022 and 4.6% by the end of 2023 before declining to 3.9% by the end of 2024. Fed Chair Powell warned monetary policy needed to be "more restrictive or restrictive for longer".
One theme to consider – the current environment (i.e., Fed's hawkish dot plot & equity market sell-off) could be closer to peak hawkishness than markets realize. Everyone, including the Fed, knows two things: (1) the Fed is making monetary policy based on the rear-view mirror and (2) tightening historically operates with a lag. Peak hawkishness doesn't necessarily mean the S&P 500 bottom is already in or that a bottom is near, but it could signal a shift in narrative. However, trying to time the shifting narrative is impossible and the equivalent of gambling.
Positioning traditional assets in portfolios in the current environment is both difficult and frustrating. Our previous reports discussed the market's confusion and lack of direction. Inflation and Fed policy uncertainty leave the market vulnerable to rapidly-changingnarratives. Performance trends are based on speculation and rumor, not fundamentals and macro data, and probabilities change as the market narrative shifts.
If the thesis was that inflation had peaked, the thesis has changed. And with change comes opportunity. The new regime of higher interest rates and inflation is one we have not seen in several years. It appears fairly obvious that relying on the what has performed well under the low rate regime may not be the best strategy going forward. The economy has experienced higher rate and inflation regimes, and history can provide hints of how to position. For instance, value has historically outperformed growth in similar environments. Factor investing could come back into favor over pure beta. Alternative strategiessuch as commodities and managed futures have underwhelmed in a low-rate world, but higher rates and inflation are more favorable conditions for both.
With continued commitment to fundamentals, process, diversification, and risk management we are not beholden to inaction, and these are some areas to consider.
