Navigating Turbulence: Strategies for Investors Amidst the Interest Rate Pause
In the year 1995, Kristina Hooper entered the world of investment, a time when both the Dow and S&P 500 experienced significant increases of over 30 percent. This starkly contrasts with their respective declines of 9.4 and 20 percent as of Thursday morning in 2022. Furthermore, this was a year following the Great Bond Massacre of 1994, which occurred due to central bankers raising interest rates in response to inflationary pressures.
At that time, the United States Federal Reserve rate reached its peak of six percent in February 1995, double the rate from the previous year. The second-to-last increase in that cycle, which took place in November 1994, amounted to 75 basis points. Interestingly, this was the last time the Fed implemented such an increase until this past June.
Fast forward to the present day, where Hooper currently holds the position of chief global market strategist at Invesco Ltd. Overseeing approximately US$1.4 billion in assets, she finds herself in a strikingly similar situation. However, the stock markets are now experiencing a downward spiral, and there are minimal indications that central bankers will abruptly change course.
Reflecting on the events of '94 and '95, Hooper notes that the cycle unfolded rapidly within a few months. In contrast, current central bankers have expressed their intentions to maintain their terminal rate for a considerable period before making any cuts.
Moving on, here are Hooper's expectations:
Financial Post: Everyone is eager to know when central banks will cease their battle against inflation and begin cutting rates. Can you shed some light on this?
Kristina Hooper: We are at a point now where the focus is not solely on inflation but also on avoiding a significant recession. The yield curve inversion between the 2s and 10s has been particularly extreme for Canada compared to the U.S. This shift indicates a more holistic approach to the economy, with the goal of reaching a normal rate hike of 25 basis points. Nonetheless, a pause remains necessary at this juncture.
FP: Assuming inflation is tamed to some extent in the future, could the situation resemble what was once considered normal before central banks targeted a two percent inflation rate?
KH: It's difficult to determine if they would be content with four percent. However, I can envision a scenario where they are comfortable with 2.8 or three percent. This does not imply an immediate rate cut, as waiting to observe the cumulative effects of significant actions is crucial. We are aware that there is a time lag associated with these effects.
FP: Are there any metrics that investors should prioritize, which often receive less attention?
KH: Certainly, job openings provide insight into the road ahead in the coming months. We have observed a decrease in JOLTS job openings in the U.S., although not as much as desired. However, we still remain significantly higher than pre-pandemic levels. Additionally, monitoring consumer inflation expectations is essential. Many strategists place excessive focus on market-based measures, whereas central banks emphasize consumer inflation expectations, which have been relatively positive thus far. Nevertheless, there have been slight increases in the New York Fed and Michigan readings in recent months, warranting attention.
If we wish to thoroughly analyze inflation, various factors must be taken into account, such as the global supply chain pressure index, which has witnessed a significant decline. Specifically, container shipping costs have considerably decreased, falling under the goods component. The services component, on the other hand, poses a real challenge, particularly due to wage growth, and naturally, the housing component cannot be disregarded.
FP: The traditional saying advises us to stay invested in the market without trying to time it. However, whenever the Federal Reserve, the Bank of Canada, or new debt figures make headlines, investors tend to react quickly and make impulsive decisions. Shouldn't we practice more patience?
KH: Absolutely. We have always emphasized the importance of taking a long-term approach, as humans are notoriously bad at timing the market. By diversifying our investments and focusing on the long run, we often achieve the best results. That being said, there are those who are interested in tactical positioning. Nonetheless, we strongly encourage investors to have a long-term perspective, as it helps to smooth out the inevitable bumps and volatility, especially when backed by a diversified portfolio.
FP: Looking ahead to next year, how should we position ourselves?
KH: At the moment, a more defensive strategy is advised, while keeping an eye on the potential for a quick market recovery. Equities should still have a place in your portfolio, but with a defensive tilt towards larger-cap, low-volatility options. The defensive sectors in the stock market should be favored. In fixed income, focus on sovereign and investment-grade credit. Investment-grade bonds can remain a significant part of a portfolio, even as the market starts to favor risk assets in a positive environment. Eventually, there will be a shift from a defensive to a more risk-on stance, but that will only happen when a Fed pause becomes imminent.
FP: So, we will be closely watching rates and inflation again.
KH: Let's face it, the actions of the Fed and other central banks have shaped the course of 2022, and there's no reason to believe they won't continue to play a crucial role in 2023. The questions for 2023 will be when they will hit the pause button, and what the terminal rate will be. After that, investors will be interested in when the central banks will start cutting rates. However, before all that, I predict that a stock market recovery will begin before or in conjunction with a Fed pause.
I don't anticipate it being a strong recovery due to the unusual timing this time around. We find ourselves in a compressed business cycle, with economies entering a downturn or recession at the same time that stocks are expected to rise. Rate cuts typically drive stock market gains, but I believe a pause will suffice. However, this will be counterbalanced by ongoing earnings downgrades, so the market rally won't be as robust. It will be more moderate in nature, tempered by significant earnings adjustments.
This interview has been edited and condensed.
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