Investors and policymakers hoping for signs that inflation is cooling were undoubtedly disappointed last week. The latest Consumer Price Index (CPI) release showed that inflation is not only picking up speed — climbing by a 40-year high of 7.5% in January — but spreading beyond corners of the economy hit hardest by the pandemic.
With inflation running hotter than expected, the Federal Reserve appears poised to tighten monetary policy at a faster pace than previously anticipated:
- Following last week’s CPI release, James Bullard, president of the Federal Reserve Bank of St. Louis, told Bloomberg News that he has become “dramatically” more hawkish and supports raising interest rates by a full percentage point by the start of July.
- Market expectations for rate increases have shifted dramatically since the start of the year.
- In mid-January, investors assigned a less than 5% probability to a cumulative rate hike of 175 basis points (1.75%) by year’s end. As of yesterday, investors were pricing in a roughly 30% chance of an increase of that magnitude by mid-December, according to the CME Group’s FedWatch Tool.
- The possibility of a more-aggressive Fed response pushed the yield on the two-year Treasury — which typically tracks short-term rate expectations — up by more than 21 basis points to nearly 1.6% last Thursday. That marked its biggest one-day jump in yield since 2009.
What does all this mean for U.S. stocks?
- Research shows that risk assets can continue to do well even when the Fed is hiking rates, but the ride is likely to be choppy.
- Since 1964, on average the S&P 500 has tended to rise in the six months before a Fed rate hike and in the three months following, according to an analysis by Renaissance Macro Research.
- The same analysis shows that market volatility (as measured by the VIX Index) has tended to rise in the months leading up to a Fed rate hike. This year, we’ve already seen sharp price moves and rotations in equities.
- A recent Barclays analysis found that during the last four rate-hiking cycles, equity markets generally performed well in the months before the first bump in rates. Equities typically saw a “mild, short-lived sell-off” in the first couple months following initial rate hikes, but then resumed their upward trajectory as the Fed continued to tighten.
As the recovery has unfolded, the Fed has been careful (some might say too careful) to wait until the U.S. economy is on firm footing before pumping the monetary policy brakes.
In fact, even as prices and COVID-19 cases soared in January, the economy created far more jobs than expected. Wage gains also accelerated, and the labor pool expanded.
So far, S&P 500 corporate earnings for the fourth quarter have been strong, with the majority of reporting companies (77%) beating estimates. Corporate profit margins increased by more than 20% in the third quarter on a year-over-year basis.
We think equities still have room to run, but market dynamics are likely to shift as the recovery matures. Until now, investors have tended to favor the riskiest areas of the market. But as we move into a new phase of the market cycle, we expect quality stocks (i.e., those with reliable growth models and strong balance sheets) to outperform. At this inflection point, it may not only make sense to favor quality, but for investors to make sure their risk profile is aligned with their tolerance.
The opinions expressed in this commentary are those of the author and may not necessarily reflect those held by Kestra Advisor Services Holdings C, Inc., d/b/a Kestra Holdings, and its subsidiaries, including, but not limited to, Kestra Advisory Services, LLC, Kestra Private Wealth Services, LLC, Kestra Investment Services, LLC, Kestra Investment Management, LLC, Bluespring Wealth Partners, LLC, and Grove Point Financial, LLC. The material is for informational purposes only. It represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. It is not guaranteed by any entity for accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was created to provide accurate and reliable information on the subjects covered but should not be regarded as a complete analysis of these subjects. It is not intended to provide specific legal, tax or other professional advice. The services of an appropriate professional should be sought regarding your individual situation. Kestra Advisor Services Holdings C, Inc., d/b/a Kestra Holdings, and its subsidiaries, including, but not limited to, Kestra Advisory Services, LLC, Kestra Private Wealth Services, LLC, Kestra Investment Services, LLC, Kestra Investment Management, LLC, Bluespring Wealth Partners, LLC, and Grove Point Financial, LLC does not offer tax or legal advice.