Concerns about the rate hike cycle could prove unfounded and provide a buying opportunity - so long as the Fed can deliver a soft landing
Recent months have been difficult for the stock market, and following a series of rate hikes, the path is certainly no clearer. Lingering uncertainty about the pace at which rates are rising has damaged investor sentiment. Principally, this has hurt rate-sensitive growth stocks.
In conjunction with anxieties about rampant inflation, these factors have acted as a headwind in dragging down other stocks that might have once been considered as less sensitive to interest rate movements - for example, take the banks.
But the reason these names are feeling the pressure this time around is because investors are worried monetary policy tightening could take place too quickly, and in turn give rise to the prospect of a global recession.
In our view, however, if central banks, led by the Federal Reserve can manage this rate hike cycle prudently, there are enough signs that suggest stock valuations are increasingly getting more attractive.
Three rounds of rate hikes
This month we’ve seen the Reserve Bank of Australia make a drastic shift to tighten monetary policy. While RBA Governor Philip Lowe previously set a 2024 timeline for the first rate hike, and subsequently watered that down to 2023, the nation’s central bank was forced into a spectacular backflip at the start of May.
Representing the first rate hike in Australia for over a decade, the RBA lifted the official cash rate by 25 basis points to 0.35%.
This was driven by the first-quarter inflation reading, which came in at 5.1%. It was a worrying sign given the RBA had ample opportunity to look abroad to the challenges that would no doubt drive inflation higher.
With that said, although the RBA might be behind the eight-ball, the US Federal Reserve has hardly been on top of the game with regards to combating inflation.
Shifting significantly from its “transitory” remarks, the Fed, led by Jerome Powell, raised rates for the first time in four years back in March, but it has since upped the ante.
Just days after the RBA hiked rates, the Fed pushed through a 50 basis point hike, its biggest in 22 years. At the same time, it has also signalled that 50 basis point hikes could be on the agenda at each of its meetings over the coming months.
Not to be outdone, the Bank of England also pushed through a rate hike in the same week. The BOE has been more proactive in moving rates higher, on this occasion delivering its fourth consecutive hike, but it has also sounded the alarm that it still expects inflation to potentially accelerate from here and reach double-digits.
Don’t fight the Fed
The biggest reaction to the week’s three rounds of rate hikes was arguably saved for the Bank of England and its warnings on inflation and the risk of a recession. However, we feel this setback is confined to the region, largely driven by a more direct impact arising from the war.
Furthermore, this should not take away from the immediate response to the Fed’s rate hike, which was treated somewhat positively and initially led to a relief rally. As the world’s most-watched central bank, we believe it is their policy response that will largely dictate how equity markets respond over the coming months.
After all, the Fed kick-started a bull run in the midst of the pandemic through its ultra-loose accommodative monetary policy, even as other central banks followed suit. This is one of the factors that has been at the heart of the common catch-cry in financial markets - “don’t fight the Fed”.
It is for this reason, we’re taking particular note in the Fed’s intention to deliver a soft landing as it lifts rates. Markets were relieved that the Fed opted to deliver a 50 basis point hike instead of 75 points as some had feared.
The fact that the central bank is prepared to deliver a series of more-proportioned hikes, as opposed to playing a quick catch-up program, gives rise to some confidence that it can effectively manage the rate hike cycle while taking in any new developments as they occur.
What we must also note, is that rates were pushed to rock-bottom levels in a fashion that we had never seen before. The Fed implemented emergency cuts back in 2020, while doing so from what was already a relatively modest starting point.
But in the grand scheme of things, long-term interest rates have occupied much higher levels over time. It would be unsustainable for central banks, let alone the Federal Reserve, to maintain rates at or near current levels, especially with inflation showing no signs of abating following the impact of the war in Ukraine.
For this reason, we expect rates to return to more ‘normalised’ levels, and the benchmark rate of 2.5% is often cited as a “neutral” level for the economy. In targeting this level, we take confidence in Jerome Powell’s commentary that effectively ruled out the prospect of 75 basis point hikes moving forward.
What’s more, Powell has also voiced confidence in the ability to deliver a soft landing for the economy, citing the prospect of restoring price stability given the underlying strengths in the US economy. This has been led by a resilient labour market that can afford to see slower jobs growth that caps wages growth as well.
The central bank has also hinted that the share market will be a consideration, among others, as part of a broader measure of “financial conditions” when framing the pace and scale at which it lifts rates.
With this in mind, we feel the Fed has no interest in unnerving investors, as this could flow through to having an impact on the economy at large.
Money flow between asset classes
Another factor that we believe supports equities at this time is the likely ramifications for the property market.
As rates increase, we expect to see cooling demand for property. The property market tends to lag the stock market when it comes to performance, so the set-back we’ve seen unfold across equities to start 2022 could reach property assets as borrowers and would-be borrowers start to feel the direct impact of rate hikes.
It is our view that higher borrowing costs could have a negative impact on sentiment in the housing market and drive investors to other asset classes.
With stock prices recently recalibrating in response to rate hike concerns, including a near 25% drop in the Nasdaq from its peak, a growing number of stocks are starting to look ‘cheap’ for the long-term.
In the growth category, a number of high-quality names are largely shielded from higher rates, notwithstanding the impact on businesses with distant cash-flow or those yet to turn a profit.
As we detailed in our January newsletter, the initial shock amid a new rate hike cycle is nothing new. In fact, history suggests the post rate-hike cycle has historically turned positive five months after the first increase, before accelerating from there.
With more and more opportunities emerging by the day, it leads us to believe that astute buying could prove rewarding over the long-term, especially as money flows back into equities from other assets.