There were no surprises at the recent U.S. Federal Reserve’s (the Fed) FOMC Meeting. The target rate moved another 25 basis points higher to 1.75% – 2.00% and their economic outlook and updated projections will likely keep the Fed on course for two more hikes this year.
Since taking over, Fed Chair Powell has remained on his predecessor’s path of gradual tightening while balancing a potentially inflationary backdrop amongst global economic risks. While much of his policy is the same, Fed Chair Powell has indicated and seems to be adhering to a pullback of forward guidance in future meeting minutes, which the market has become accustomed to and needed since the financial crisis.
On one hand, this position on forward guidance allows the Fed more flexibility without causing shocks to the market. However, it also raises concerns that with more rope, the Fed could overshoot with their policy and push the economy into a recession.
In our opinion, too much tightening by the Fed is a major risk factor and should be considered when making investment decisions. In this environment, we believe there will be relatively muted equity returns compared to recent years and a flattening yield curve as short-term rates pushing higher.
SAME TRAJECTORY BUT LESS GUIDANCE
Under the new regime of Chairman Powell, the Fed has stayed on their previous trajectory with measured rate hikes up to this point in the year. The Fed pointed to robust economic growth during its June meeting, replacing ‘moderate’ with ‘solid’ to describe economic activity, which indicates they will likely at a minimum stay on the current course. However, we believe there are signs this path could change going forward, and especially into 2019. First, cutting back on their forward guidance by not explicitly stating what they expect to happen has essentially given the Fed more flexibility to raise rates faster without creating ‘surprise’ shocks to the markets. Secondly, a lot of focus seems to be on the low unemployment rate in the U.S. and the implication that low unemployment will lead to higher wage pressures, which would be inflationary. Finally, there are a growing number of factors independent of the Fed that could result in more tightening than intended. Coupled with a too aggressive Fed, these factors could push our economy over the tipping point.
OTHER SOURCES ADD TO THE TIGHTENING
For example, balance sheet normalization in the U.S. is fully underway and the ECB announced it will follow suit beginning late this year. While neither central bank is outright selling securities in the market, this passive rolldown with no reinvestment leads to less demand than the market has become accustomed to and, therefore, may drive the interest rate for certain securities higher to entice demand. As rates move up, this passive tightening can exacerbate the impact of rate hikes implemented by the Fed and should cause some concern for investors.
Additionally, investment grade credit spreads have widen recently following a period of tighter spreads relative to historical levels. As debt service becomes more expensive, we could see less spending from the corporate sector. This is another source of tightening that occurs independent of Fed action as the market begins to demand a higher risk premium to hold corporate debt.
Other factors come into play as well that relate to money supply. For example, small business lending has accelerated and we also have the potential for tax relief from the tax cuts that went into effect at the beginning of this year. While those are positive for the money supply, a rising U.S. dollar and more hurdles for consumer credit can detract. Therefore, it is important to consider the growth of the money supply as an indicator the Fed may overshoot with rate hikes. For example, we are watching inflation-adjusted M1 growth closely. A negative growth rate of inflation-adjusted M1 could be a sign of a Fed overshoot and an economic downturn.
Finally, geopolitical risks continue to surface that are potentially a threat to the economy and create volatility. While these issues are typically not foreseeable, we think the Fed should allow some room for these risks in their trajectory.
HOW TO POSITION YOUR PORTFOLIO
Currently, we have reason to believe the Fed will stay on course despite these other factors and are invested accordingly. We expect the broad equity markets to continue advancing at relatively muted rates compared to recent years due to several factors, such as the ones discussed above. In this environment, investors may want to tilt their exposure to more defensive sectors, such as healthcare, REITS, and minimum volatility equities. Alternative strategies can also be beneficial in this environment, especially those that offer downside protection compared to a traditional equity holding. As for fixed income, we expect to see the yield curve flatten with the longer end showing more resistance to higher interest rates. We are finding value in the intermediate duration and some longer duration sectors, as well as alternative positions in variable rate products that benefit from rising short term rates.
This article was written by Gary Stringer, CIO, Kim Escue, Senior Portfolio Manager, and Chad Keller, COO and CCO at Stringer Asset Management, a participant in the ETF Strategist Channel.
DISCLOSURES
Any forecasts, figures, opinions or investment techniques and strategies explained are Stringer Asset Management, LLC’s as of the date of publication. They are considered to be accurate at the time of writing, but no warranty of accuracy is given and no liability in respect to error or omission is accepted. They are subject to change without reference or notification. The views contained herein are not be taken as an advice or a recommendation to buy or sell any investment and the material should not be relied upon as containing sufficient information to support an investment decision. It should be noted that the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested.
Past performance and yield may not be a reliable guide to future performance. Current performance may be higher or lower than the performance quoted.
The securities identified and described may not represent all of the securities purchased, sold or recommended for client accounts. The reader should not assume that an investment in the securities identified was or will be profitable.
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