Investment Strategy

Rate hikes are back—what can investors expect?

Risks are rising, but we think the global economy should withstand the challenges ahead.

Our Top Market Takeaways for March 18, 2022.

Market update

Ready, set, liftoff

 

After some initial indigestion, stocks soared as the Fed lifted off with its first rate hike since 2018 and Russia made moves to avoid defaulting on its debt payments. Heading into Friday, the S&P 500 had wrapped up (and closed out St. Patrick’s Day) with its largest three-day green streak since November 2020. The Stoxx Europe 600 was less than 1% off the levels seen just before Russia invaded Ukraine. Even downtrodden Chinese stocks saw a boost after policymakers pledged support as lockdown risks mount.

Yet more notable has been the swift and large move higher in rates. So far this month, 2-year Treasury yields have jumped a staggering +48 basis points (bps) to 1.92% (on track for the largest monthly leg higher since 2008!), while the 10-year has popped +35 bps to 2.17%.

The upward march comes as the Fed solidified its more aggressive stance at this week’s meeting—it now plans to hike rates quickly and consecutively until something (such as a growth threat that derails demand) tells it not to. With inflation soaring and a strong labor market, economic conditions are inconsistent with still emergency-era levels of support.

The latest forecasts show the median FOMC member expects to bring the central bank’s policy rate to 1.9% by the end of the year, implying a 25 bps hike at each of its remaining six meetings (with a 50 bps still on the table). And it plans to keep going in 2023 until the fed funds rate reaches 2.8%—above the 2.4% it estimates is the “friction zone” where borrowing costs start to pinch growth.

This chart shows the implied Fed policy rate from today to December 2022, and the number of hikes priced into the market. In March 2022, the implied rate is 0.3% with 1 hikes priced in. In May, 0.7% with 2.4 hikes priced in. In June, 1.0% with 3.7 hikes priced in. In July, 1.3% with 4.8 hikes priced in. In September, 1.5% with 5.8 hikes priced in. In November, 1.7% with 6.5 hikes priced in. In December 1.93% with 7.4 hikes priced in. The median Fed committee member expected 1.88% by year-end.

This hawkish path showcases how a high-inflation, slowing-growth environment presents a challenge for central bankers—hike rates too much, and you risk exacerbating unemployment; do nothing or cut rates, and inflation could spiral further. At the press conference, Chair Powell acknowledged that the risks are growing around stagflation, aka economic stagnation (with slow growth/rising unemployment) and high inflation. The last time we saw such an environment was the 1970s, and it was a mess: The economy and markets were plagued by widespread food and energy shortages, soaring interest rates and a lingering selloff. 

Landing the plane through effective policy won’t be without turbulence, and central bankers have a narrow runway to get it right. To gauge the path forward, it’s worth dissecting both sides of the inflation-growth coin.

Spotlight

Navigating high inflation and slowing growth

 

With oil prices above $100/barrel, no clear end in sight to the Russia/Ukraine crisis, and now rate hikes underway, are we falling into another stagflationary trap? 

The punchline:

Risks have undoubtedly risen, and higher inflation and slower growth (compared to expectations at the start of the year) seem to be on the cards. But the price action this week suggests that investors are finding solace in the underlying strength of the U.S. economy. While the expansion may be dented, we do not believe it’s been derailed.

Let’s break it down.

On inflation:

The bad news:

Before the current crisis, inflation across the world was already at multi-decade or record highs. As we face the uncertainty of war, it looks like a longer road for inflation to meaningfully moderate, even as consumers shift their spending back toward services from goods, and base effects come into play. At this week’s meeting, the Fed said it expects core inflation in 2022 to round out at 4.1%, notably higher than the 2.7% it expected in December—and it anticipates inflation to stay above 2% through 2024.

The rise in commodity prices is even more problematic for Europe. Energy had already accounted for half of the region’s rise in consumer prices in 2021, and it sources 20% of its energy consumption from Russia. 

The good news:

In the United States, while market-based measures of long-term inflation expectations have jumped as crude prices have rocketed (10-year breakevens are near their highest since data starts in 1998), it’s worth noting this is largely due to expectations for inflation to be more elevated over the next year or two, rather than permanently. Consumers seem to agree with this sentiment: Expectations for inflation over the next three years are notably lower versus one year ahead. This suggests that Americans believe they can weather the storm of higher prices—a prescient point for those worried about a wage-price spiral.

This chart shows the U.S. median expected inflation rate one year ahead and three years ahead from 2013 to February 2022. From 2014 to 2020, these expectations were generally in line. They began around 3.2%, steadily falling to 2.5% in January 2016. They picked up to 3.0% by February 2017, dipped slightly, then rose again to 3.0% in October 2018. They fell to 2.4% in October 2019 and rose from there. They reached around 3.6% in May 2021. At this point, the two diverged. One-year ahead expectations skyrocketed to 6.0% in December 2021. They dipped, then rose again to 6.0% in February 2022. Three-year ahead expectations rose to 4.2% in October 2021, fell to 3.5% in January 2022, then rose again to 3.8% by February 2022.

On growth:

The bad news:

Price pressures, higher interest rates, and uncertainty around commodities and supply chains are all conspiring to pressure growth. Since the start of the year, economists have downgraded their growth expectations for the year—with the most acute pain expected in Europe.

This chart shows the downward GDP revisions from December 2021 to March 2022 (% ppts) in four regions. • Euro Area: -2.3 • United States: -0.6 • LatAm: -0.2 • EM Asia: -0.1

The good news:

Growth looks likely to slow from here, but it’s critical to remember that the backdrop is still one that is fundamentally healthy. Across the United States and Europe, consumers are on strong footing. U.S. household wealth is 13.5% higher than pre-pandemic levels (suggesting ample wiggle room for higher fuel and energy costs), debt servicing costs remain low, and the labor market grows tighter by the month (the U.S. unemployment rate is at 3.8%, and in the Eurozone, it’s the lowest it’s ever been). Similarly for corporates, margins are still near record highs, earnings revisions are trending higher, and plans to invest in capex and return value to shareholders have increased.

This chart shows the 2022 year-end earnings per share estimates for the S&P 500 and Stoxx 600 (in dollars and euros respectively) from April 2021 to early March 2022. The S&P 500 EPS began at 209, rising steadily to 213 in June 2021, 219 in September 2021 and finally 227 in March 2022. For the Euro Stoxx 600, EPS estimates began at 27, rising steadily also to 29 in September 2021, 30 in December 2021 and 32 as of March 2022.

Further, governments in Europe have signaled their intention to lend support (such as through EU bond sales to fund energy and defense spending), mitigating at least some of the economic strain.

Investment takeaways

Cautiously optimistic

 

Calibrating the path forward is wrought with uncertainty, but the resulting volatility also brings new opportunities to the fore.

Higher inflation and interest rates provide a compelling case to get out of cash and consider other liquidity options and the role of bonds in your portfolio.

Further, roughly one-third of S&P 500 companies are currently in bear market territory (more than 20% off their 52-week highs)—and some stocks look too black and blue than their fundamentals would otherwise merit. Quality companies (those with healthy balance sheets, demonstrated ability to compound earnings, and robust ESG scores) are broadly trading at a discount, and we see opportunity in such stocks across sectors.

Your J.P. Morgan team is here to discuss what strategies might be right for you.

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All market and economic data as of March 2022 and sourced from Bloomberg and FactSet unless otherwise stated.

We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice.

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