June 16, 2022
The Fed delivers a larger than expected 75-basis-point hike
For the first time in 28 years, the Federal Reserve (the Fed) raised the Fed Funds Target Rate 75 basis points (bps). Chairman Jerome Powell noted that last week’s reacceleration in inflation was material in it becoming more assertive in moving from a 50-bps to a 75-bps increase in the policy rate.
We view this larger than expected rate hike as a first step to restoring the Fed’s credibility on slowing inflation. It is now clear to us that the Fed is determined to materially decrease inflation and bring it closer to its target rate.
Investors can expect tighter financial conditions and policy rates, which limit upside for equity valuations while exerting downward pressure on fundamentals including corporate earnings.
The Fed will “front-load” rate hikes, the goal of which is to meaningfully slow inflation sooner rather than later.
The Fed’s statements highlighted that the economy is more resilient than we thought — this leaves the door open for faster rate hikes and gives the Fed flexibility going forward.
Fixed Income Markets
- There was not much of a reaction in the fixed income markets to the Fed’s announcement. Following the Fed’s action and press conference, U.S. Treasury yields were relatively unchanged. Credit spreads were also stable.
- We continue to expect interest rates across the yield curve to rise with the yield curve remaining flat and inverted at certain points. We are keeping a close eye on the yield curve as a full inversion of it would indicate a recession is around the corner. Our positioning reflects this view by being shorter duration, barbelling our yield curve positioning and being relatively higher in credit quality.
- Equity investors largely discounted the move leading up to the meeting, with markets having declined more than 10% from peak to trough in June. Following the Fed’s decision, there was a strong rally in equity markets.
- As long-term inflation expectations continue to move higher, this has implications for equities as inflation cuts into companies’ margins. In the near term, this means equity earnings will be challenged as companies will be hurt by higher input cost and consumers with less disposable income due to inflation. However, it will take some time for rate hikes to fully trickle down into corporate fundamentals.
- We continue to advocate for defensive positioning in equities favoring segments exhibiting quality and yield. We find the most recent decline in equities to have made some entry points more attractive for long-term investors.
- The unmistakable takeaway from the Federal Open Market Committee’s policy statement, the summary of economic projections and Powell’s press conference is that the Fed has restoring price stability as its paramount goal. The more aggressive and front-loaded rate tightening is aimed at dampening the rapid pace of inflation and stemming further large increases in consumer inflation expectations.
- We expect the Fed to remain laser focused on slowing inflation and continue to raise rates by either 50 bps or 75 bps at the July meeting. However, Powell re-emphasized that the Fed needs to remain dynamic in adjusting the stance of policy based on new economic data and the economic outlook.
- Volatility will persist across stock and bond markets until there is greater clarity on the path of inflation (we think it will be lower by the end of 2022); the Russian invasion of Ukraine; and China’s stop-start COVID policy, which is straining global supply chains.
- Given the market turbulence and a rising probability of both a recession and stubbornly high inflation, we think portfolios should be underweight long-term strategic allocations to equities and overweight allocations to cash for now. We see opportunities to diversify income sources and raise the quality of portfolios during this volatile period across asset classes. Where possible, alternative assets like hedge funds, commodities and private credit investments are attractive additions to portfolios.
First Republic Private Wealth Management encompasses First Republic Investment Management, Inc., an SEC-registered Investment Advisor, First Republic Securities Company, LLC, Member FINRA/SIPC, First Republic Trust Company (“FRTC”), First Republic Trust Company of Delaware LLC (“FRTC-DE”) and First Republic Trust Company of Wyoming LLC (“FRTC-WY”).
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