Following yesterday’s meeting, the decision to hike rates seems to indicate the FED will disregard the markets and focus on “fighting the inflation”. How tenable is such a stance?

What happened

Yesterday the FOMC held its first meeting of 2022 and, more importantly, the first such meeting since the pivot to a hawkish stance last November that caused jitters in the markets. 

Many expected a more dovish than priced FED, and so the markets had rallied, front-running this outcome. While the FOMC statement indeed toned down the most hawkish expectations, contributing to another short relief rally, the press conference of the FED Chairman, Jerome Powell, went the opposite direction, reminding of his December 2018 performance. His hawkish comments led the market to lose more than 3.5% during the Q&A session.

Indeed, many of his comments were interpreted as more hawkish than what the official statement seemed to indicate. The latter was by and large in line with what the market expected, even somewhat more dovish given the reduced emphasis on quantitative tightening. In his comments, Jerome Powell was more hawkish, as this few examples show:

• He cited March as the date for the first rate hike. The statement said “soon”.
• He indicated that there is room for rate hikes before hurting the job markets.
• He did not deny nor exclude a more hawkish path, such as hiking rates at every quarterly meeting (or more) or even 50bp at once.
• He affirmed that the FED has no control over the yield curve shape and that an inverted curve may not be enough to stop the hiking cycle.

By adopting a hawkish stance to almost every answer, Jerome Powell led the market to price five rate hikes by December ’22. The 2Y yield jumped the most since March 2020, and the 5s30s curve is now almost flat at 25bps.

This performance starkly reminds his December 2018 press conference with his now-infamous “autopilot” comment. In other words, he chose inflation over the market. However, as we believe growth and inflation expectation are trending down, he will be challenged by the market and eventually pivot.  

Impact on our investment case

Markets prefer a narrow distribution of outcomes. Powell, by not excluding very restrictive moves during the press conference, widened the range of possible options, thus increasing uncertainty. Thus, some further turbulences are likely ahead of us.

Nevertheless, we continue to believe in the quality of our portfolios, and expect a more dovish than expected FED in the coming months, given the economic outlook.

As explained in our recent article, market pricing and investors’ sentiment are extremely negative. The major indices, being heavily skewed by the weight of big tech (GAFAM), hide the brutality of the broad sell-off. Since the beginning of the FED pivot to a hawkish stance in mid-November, the average stock in the Nasdaq Composite has lost half of its value. This is quite unusual if we consider that, following the Covid recession, we are still in the early phases of a new business cycle. After the initial expansion, expectations about the economy and inflation are slowing to a more normalized growth rate, but this would not imply a recession unless engineered through an error in monetary policy. 

Our macro analysis continues to suggest that both growth and inflation will slow down this year, thus suggesting the FED should not be as restrictive as indicated by its chairman and priced by the market. The latest macro-economic numbers seem to confirm this view :

• PMIs are trending down and are below expectation. For example, the Markit Composite PMI at 50.8, excluding the pandemic's depth, is the lowest since February 2016.
• Similarly, Initial Jobless Claims have stopped to go down and, since November, are rising back up.
• Also, the retail inventories surged to a record of 4.4% MoM. This record increase over the last months suggests the worst of the supply chain disruption is behind. Thus, lower inflation in goods is probably coming.

We continue to believe that growth is slowing and that high inflation, mainly coming from the supply side that (as shown by retail inventories) is already starting to normalize, remains transitory.

But equity markets (and bond markets through the flattening of the curve) appear to be pricing a higher probability of recession, thus implying a policy mistake by the FED. Indeed, by raising interest rates, the FED cannot solve the supply-side issue, but could significantly impact the demand side, sending a slowing economy into a tailspin. 

Moreover, certain parts of the forward curves are as flat as when approaching the end of a hiking cycle, suggesting a very limited number of possible hikes going forward. Indeed, the quantitative tightening has been only marginally pushed forward in the FOMC statement. But the recent move in the USD has in itself already tightened financial conditions. With a trade deficit of more than $100bn last month, and growth-related macro-economic numbers trending down, economic growth prospects are not as bright as some expect. Thus, even after this hawkish press conference, we consider that there is a higher chance of having a more dovish than expected FED during the course of the year.

Our takeaway

Our stocks have been hit since November FED’s pivot to a hawkish stance. Nevertheless, they have proven business models and generate positive cash flows. We have shown how many high-quality growth stocks are, on various metrics,  becoming extremely cheap by historical standards. On the opposite, value stocks are becoming expensive.

As explained in a previous note, the rise of interest rates and inflation are not necessarily damaging the growth sector. In fact, it is at the onset of the rate hiking cycle that growth stocks suffer the most, but as history shows, growth stocks sail well into the hiking cycles. In fact, the need for technology allows these firms to have better pricing power than most and are able to accommodate the effects of inflation.

While the press conference was more hawkish than the FOMC statement, we believe that the FED will not tighten as much as expected given the current slowing growth environment and lower inflation in the coming months. 

With the current extremely bearish sentiment combined with the attractive valuation for high-quality growth stocks, we believe our portfolios are likely to outperform in the coming months.