A Fed pivot shouldn’t signal the all-clear to investors

Quick Read

• Monetary policy has long and variable lags. 2023 may be the year that the long-awaited growth slowdown unfolds. What this means for markets is we think the latest risk asset rally could be overdone.
• Positioning-wise, near-term we like short-term investment grade bonds and Treasuries. Over the longer-term, we like high yield bonds, dividend stocks and covered calls.

A Fed pivot shouldn’t signal the all-clear to investors

History shows that monetary tightening negatively impacts growth well after the last interest rate hike.

2022 was about inflation, inflation, inflation. Thankfully, and finally, the October CPI print showed the first signs of slowing inflation and markets rejoiced at the prospect of the Federal Reserve having some leeway to stop aggressively hiking interest rates. Whether the Fed pauses early next year or not, history suggests changes to monetary policy impact the economy with long and variable lags so investors would be wise to remain wary in 2023.

We analyzed 10 hiking cycles since 1950 to assess when monetary tightening has the biggest impact on growth. The conclusion is that it’s not unusual for the economy to remain relatively strong throughout a Fed hiking cycle, and only later, typically the following two years, does growth begin to weaken materially.

As the chart below illustrates, personal consumption, non-residential investments (think business capital expenditures) and government spending remained well in positive territory as the Fed was raising interest rates. Over time, tighter policy accumulates and growth begins to falter with non-residential business investment and consumption the biggest drivers contributing to a deceleration in GDP. This makes sense – the whole reason the Fed hikes rates is to slow a booming economy and prevent overheating. Against this prosperous backdrop while the Fed is hiking, businesses and consumers tend to feel confident spending. Ultimately though, the tighter financial conditions slowly trickle into business decision-making and household spending, which often precipitates the pause in hiking.

Contribution to GDP Deceleration

The notable exception to this timeline is residential investment. Again, this is logical – the impact of higher Fed Funds rates is almost immediately passed on to higher mortgage rates, leading to a slowdown even early in a hiking cycle. By the time the Fed pauses, however, most of the damage has been done and activity tends to rebound modestly after a period of restraint. Another caveat is net exports, which have on average been positive after the Fed pauses but this is often due to weakness in imports which is another manifestation of a decelerating domestic economy.

The bottom line is that monetary policy has long and variable lags and even if the Fed stops hiking early next year it will take time for the full impact to be felt. Thus, 2023 may likely be the year that the long-awaited growth slowdown unfolds.

How does a potential Fed pivot translate to positioning?

All of this matters because risk assets have staged a strong rally of late that we think could be overdone. From our perspective, investors would be wise to think about their investment opportunity set in stages: near-term and longer-term opportunities.

Amidst what’s likely to be a period of slower growth and market volatility over the coming months and quarters, we like short-term investment grade bonds. They offer the highest yields seen since 2008 and potential resiliency, with significantly more return potential than pure cash. We would put Treasuries in this category as well.

Over the longer-term, we like high yield bonds, dividend stocks and covered calls. We acknowledge that credit spreads could widen further, but for investors with a slightly longer time horizon who can withstand some short-term uncertainty, we think today’s elevated yields and lower average prices are extremely compelling. In addition to attractive valuations, fundamentals remain healthy in high yield with extensive refinancing having occurred at lower interest rates, quality of the overall space having improved over the past decade, and default expectations below historical averages. Within equities, forward Price/Earnings multiples on dividend stocks remain attractive vs. broad equity indices like the S&P 500 despite having provided significant outperformance year to date, while covered calls provide a means of generating income while still participating in equity upside.

In conclusion, despite a more defensive stance today given elevated macro uncertainty, we remain optimistic longer term. Valuations have improved across the board and the aggregate opportunity set across income markets today has become increasingly attractive. While staying selective is key, we believe there are areas of opportunity both within high quality assets as well as higher yielding fixed income and equities.