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How to play defense with the Fed

23 September 2022

We expect inflation after a sticky period to eventually come down much faster than assumed, sending relief to the equity market. Till then, the market will continue to oscillate on fears of a recession and elevated inflation. The Fed will “keep at it” until it pauses in 2023 to assess the impact of the cycle of monetary tightening. As demand eventually slows, we expect corporates to reduce very elevated profit margins fueling the eventual deceleration trend in inflation.

What happened?

The Federal Reserve hiked by 75 basis points on Thursday, as widely expected, with another probable 75 basis point hike in November to reach 4.4% by year-end 2022 (3.37% previous Dots) before a pause in 2023 to finish at 4.6% by year-end. The Chairman is uncertain about the Fed’s ability to engineer a soft landing, but is forced to keep interest rates in restrictive territory as supply pressures are not easing as fast as expected.

Risk management
The Fed’s latest rate hike comes after core inflation rose against expectations. The essence of risk management is to be extraordinarily risk averse to a bad outcome. Like a car swerving ahead of a wall, the instinct is to hit the brakes hard. The question is whether overdoing it is the right decision. Leverage is high in the United States from corporates to households, but it would take a dire outcome to undo two decades of real estate and financial market gains. The challenge for the Fed as demand and supply eventually cool is to convince CEOs that this economic slowdown is a moderate one and is much-needed in order for inflation to cool down.

Likely fiscal contraction ahead should be deflationary
With Republicans still expected to control the House after the November midterm elections a fiscal contraction is likely to dampen growth and inflation. However many US households are affected by prices increase and did not have the skills or money to move across geographies, industries and companies We could see around the midterm and presidential elections a pressure to eventually give the economy some fiscal relief but it should be limited.

What does it mean?

Faced with a very uncertain path ahead for US growth, our preference remains for stocks that offer quality, namely resilience of cash flows as the economy slows down with significant pricing power. Within these high quality stocks, we look at those that are more attractively valued. As inflation eventually slows in the US, it should also spill over worldwide. That should eventually offer opportunities in fixed income in both developed and emerging markets.

 

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