• As of today, the Fed has already raised interest rates by 75 bps. It has also signalled its intention to step up the pace of rate hikes and begin reducing its balance sheet in June.
• In light of the recent developments, we have raised our forecast for the Fed Funds Rate from 3.25% to 3.75% by end 2023.
• Riskier assets, such as SPACs, meme stocks and growth stocks that are richly valued but have negative earnings (e.g certain software stocks) are likely to be hit the hardest as rates rise.
• Generally speaking, higher interest rates should result in a slowdown in economic activity, which in turn produces an adverse effect on equity prices.
• In light of the more aggressive rate hikes, investors should consider increasing their exposure to value oriented equities and reduce the duration of their fixed income portfolios.
Fed has stepped up the pace of rate hikes
Since our previous update back in March 2022, the Federal Reserve has already raised interest rates twice. The central bank kicked started the current rate hike cycle by raising rates 25 bps in March, followed by a 50 bps rate hike in May – the steepest increment since the year 2000.
Related Article: Seven rate hikes in 2022 an increasing possibility
More importantly, the Fed signalled its intention to step up the pace of rate hikes, which could see rates go as high as 2% this year (Figure 1). In addition, it also has plans to reduce the size of its balance sheet by up to USD 95 billion per month starting in June, which should further tighten financial conditions. Prior to the March meeting Fed officials were much less hawkish, only signaling about three to four rate hikes this year.
Figure 1: Fed officials are now signalling that rates could go as high as 3% by 2023
This dramatic shift in interest rate policy comes as the Fed is now more attuned with the reality that inflation is no longer transitory, and that higher prices are here to stay. In April, consumer prices showed little signs of cooling, rising by 8.3% year-on-year – exceeding all estimates. There has also been a noticeable uptick in services inflation, as spending shifts from goods to services as the economy reopens (Figure 2).
While we expect inflation to slow in the coming months due to the high base effect and easing of supply chain bottlenecks, we do not foresee that it will moderate significantly over the course of the year.
Right now, there are still several upside risks for inflation, such as the Russia/Ukraine crisis, COVID-19 lockdowns in China and rising global food protectionism – all of which has the potential to add to inflationary pressures and are beyond the control of the Fed.
Figure 2: US inflation remains near 40 year high
Fed Funds Rate could go as high as 3.75%
In light of the recent developments, we have raised our forecast for the Fed Funds Rate (upper bound) from 3.25% to 3.75% by end 2023 (Figure 3). With inflation sky high, the central bank will most likely have to raise rates beyond the neutral rate in order to bring it down. If we look back at the past few rate hike cycles, we can see that the Fed typically tightens rates 100-200 bps above the neutral rate. Based on current economic conditions the neutral rate is estimated to be somewhere between 2.5% and 3.0%.
Over the past few weeks, Federal Reserve Chair Jerome Powell has repeatedly stressed the need to curb inflation, and has made it clear that the Fed will keep raising rates until there is “clear and convincing” evidence that inflation is falling.
In order to achieve this, we believe that the Fed will likely front load rate hikes to bring inflation down as quickly as possible. That said, we think that there is a good chance that we could see multiple 50 bps rate hikes in the coming months, which could bring the Fed Funds Rate close to the neutral rate by year end (Figure 3).
Figure 3: The Fed Funds Rate could rise as high as 3.75%
Possible implications of more aggressive rate hikes on markets
Generally speaking, a sharp rise in interest rates is likely to result in a slowdown in economic activity, which may have an adverse effect on equity prices. Riskier assets, such as SPACs, meme stocks and growth stocks that are richly valued but have negative earnings (e.g certain software stocks) are likely to be hit the hardest as rates rise (Figure 4).
Figure 4: Riskier assets, such as meme stocks have underperformed the broader market this year
As inflation remains elevated and financial conditions tighten, businesses are likely to be faced with tougher operating conditions (e.g. higher input, borrowing costs and deteriorating margins) which could result in lower earnings growth and hence lower equity prices. Companies without pricing power, and those that rely heavily on debt financing are also likely to experience greater margin compression.
As the economy slows, businesses may also dial back on production and expansion plans, which could potentially have a negative impact on the labour market. A strong labour market is often synonymous with healthy consumption growth, as consumers who are feeling optimistic about their finances and the economy tend to spend more.
Figure 5: Consumer confidence often improves along with conditions in the labour market
Aside from the health of the labour market, higher interest rates can also have a direct impact on consumers. As interest rates rise, the cost of borrowing for consumer loans (e.g. mortgages, auto loans) will also rise. Combined with the rising prices of everyday goods and a weakening labour market, consumption could start to slow in the months ahead.
Ultimately, with the Fed tightening the screws we expect the US economy to grow at a slower pace than previously estimated. GDP growth forecasts for 2022 have already been revised downwards, from 3.9% at the beginning of the year to 2.6% as of end May.
On the contrary, earnings estimates have been revised upwards since the start of the year, which we feel paints an overly optimistic view of US equities given the weaker economic outlook and mounting earnings headwind. Therefore, we expect earnings to be downgraded eventually to reflect the weaker economic outlook. That said, even though share prices of US equities have fallen due to the recent selloff, valuations are still far from being incredibly cheap.
Aside from the US, we also lay out the possible implications of the more aggressive rate hikes on Singapore and Hong Kong equities in the table below.
Table 1: Possible implications of more aggressive rate hikes on Singapore and Hong Kong equities
|
Markets |
Possible implications |
|
Singapore |
· Interest rates in Singapore generally tracks rate movements in major markets, such as the US and are thus expected to rise as the Fed tightens. · Growth momentum to ease in the coming quarters as credit conditions tighten, but may be partially offset by the economy’s reopening. · Banks, (which make up more than 40% of the STI) tend to thrive in a higher interest rates environment as net interest margins widen. · The STI’s heavier weighting towards value oriented sectors should enable it to be more resilient compared to growth heavy markets (e.g. US). · Singapore’s equity market may see inflows as more investors rotate into value oriented markets. |
|
Hong Kong |
· Because the HKD is pegged to the USD, monetary policy in Hong Kong should move in tandem with the US. · Hong Kong banks however, have maintained their lending rates to support the economic recovery – which may affect their profitability. · Mainland companies account for close to 80% of the HSI, hence its performance should largely be driven by China’s domestic policies rather than changes in the Fed Funds Rate. · Due to the ongoing revamp, tech companies (e.g Alibaba & Tencent) now have a greater representation in the HSI. Similarly, this makes the index more susceptible to changes in domestic policies such as the crackdown on China tech. |
|
Source: iFAST Compilations |
|
How should investors position themselves?
With more rate hikes on the way, now is probably a good time for investors to reassess their portfolios and position themselves accordingly. Those with growth heavy portfolios (e.g. heavy on US equities) should consider diversifying their equity exposure to include more value oriented equities as rates rise.
To that end, investors can consider the SPDR Straits Times Index ETF (SGX:ES3) for exposure to Singapore equities, which has a natural value tilt as explained above. Alternatively, those who are interested to remain within the US equity space can consider the JPMorgan Funds - US Value Fund.
This fund aims to provide long-term capital growth by investing primarily in a value style biased portfolio of US companies. Its investment philosophy emphasises on investing in high quality, conservative companies with relatively stable patterns of earnings that trade at attractive valuations, whose performance is likely to be more resilient than their growth counterparts in the current economic environment.
Related Article: US: Value to lead the way
From a sectoral perspective, we favour the financials - which are likely to benefit in a rising rate environment. For exposure to the financial sector, investors can consider the Blackrock World Financials Fund or the iShares Global Financials ETF (NYSE:IXG).
Lastly, for fixed income, investors should aim to reduce duration to protect against a faster than expected rate hike environment. Short duration bond funds, such as the Nikko AM Shenton Short Term Bond or the LionGlobal Short Duration Bond are two options worth considering.
Investors can also consider Asian high yield bonds as they provide one of the highest yield per unit of duration, which can potentially provide some buffer to offset the rise in interest rates. Our recommended products for Asian high yield bonds include the Eastspring Investments - Asian High Yield Bond Fund. Investors with stronger risk appetite could also go for the Premia China USD Property Bond ETF (HKEX:9001), which provides pure-play exposure to Chinese property bonds.
Related Article: The Asian high yield bond market is presenting attractive value for long-term investors
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