With the volatility in the markets and the macro events we’ve experienced, it’s hard to believe the U.S. Federal Reserve launched its monetary policy tightening campaign only about a year ago. Dramatic shifts in asset prices ensued, as the Fed tried to contain inflation by lifting the fed funds rate by 4.75% in 14 months — the kind of historic policy movement that left investors asking, “Are we there yet?” on inflation.
As discussed in Mackenzie Investments’ 2023 outlook report, the lagged effects of the 2022 rate hikes are likely to present bumps in the road ahead for the global economy, corporate earnings and markets. With high-quality bonds offering healthy yields again and some challenges ahead for equity earnings — implying valuations were not cheap yet — the report recommended portfolios align to a neutral asset mix.
Entering 2023, expectations were for the Fed to hike rates a few more times to slow economic growth and reduce the rate of inflation. Crucially for the Fed, some cooling of the red-hot labour market was needed to ensure that consumer prices for services fell back into line. The softening of business and consumer sentiment surveys — often leading indicators of slowing growth to come — along with a few lower monthly inflation readings initially gave the bond market room to price in fewer rate hikes ahead, and allowed equity markets to continue their bounce from Q4 into early February, buoyed by the prospects of a soft landing or even the idea of “no landing.”
In early 2023, the Bank of Canada signalled a pause in rate hikes and the possibility it would not need to hike its policy rate further. There have been initial signs that the more interest-rate-sensitive Canadian economy is responding to the 425 basis points of monetary tightening delivered by the central bank. However, Bank of Canada Governor Tiff Macklem indicated that more policy rate increases could come if inflation remains too high.
Paraphrasing Milton Friedman, economists often say that monetary policy operates with long and variable lags. Through February and into early March, after another round of strong labour and inflation data releases, Federal Reserve Chairman Jerome Powell opined that more hikes would be needed, pushing bond yields back up and softening equities once again. Fed funds futures priced in a 5.5% terminal policy rate. Some small cracks in the economic story had begun to appear in interest-rate-sensitive areas, such as housing and consumer lending, but the economy was not softening fast enough to reduce inflation before it becomes entrenched.
Just days after Powell’s hawkish testimony to U.S. Congress, there was another crack from the lagged effects of financial tightening. In early March, both Silicon Valley Bank and Signature Bank entered Federal Deposit Insurance Corporation (FDIC) receivership after experiencing significant withdrawals on their deposit bases. While their large uninsured deposit bases made them more susceptible to deposit flight, they had also experienced many unrealized losses on Treasury and mortgage-backed securities holdings. Those unrealized losses resulted from the Fed’s rate hikes that pushed up bond yields over the past year.
The Fed, FDIC and U.S. Treasury stepped in soon after with joint measures to instil confidence in bank deposits. In general, the price for depositor confidence over the months ahead might include a retrenching of lending risk within bank business models. The episode is likely to tighten financial conditions and could be a catalyst for additional economic deceleration. In the immediate aftermath, the bond market de-priced some of the additional Fed hikes that were expected from forthcoming Federal Open Market Committee (FOMC) meetings, and the FOMC delivered a more cautious hike of 25 basis points at its March 22 meeting.
Considering the market events of late, below are some strategies advisors should consider for clients to ensure portfolios are well structured and diversified to weather the storm.
A neutral approach
The case for some continued volatility in markets in the 2023 outlook report remains intact. Portfolios will benefit from diversification across equity exposures by style and geography. Financial tightening will create opportunities for active equity managers as slowing economic growth reveals both resilient and challenged business models.
Looking ahead, investors seeking more consistent equity performance may find that dividends offer a proportionally higher contribution of equity market total returns over time, compared with the low interest-rate era of the last two decades.
To help mitigate overall portfolio volatility, advisors should recommend duration-oriented fixed-income exposure, which many investors have avoided out of fear of rising rates. Investment-grade corporate bonds and government bonds are also offering some of the most attractive yields seen in high-grade fixed-income markets since the end of the global financial crisis in 2009. If the Fed, the Bank of Canada and other central banks are succeeding in reducing inflation pressures, then bond yields could earn investors a premium over inflation.
Balanced portfolios that take advantage of the negative correlation between equities and bonds can likely help keep clients invested over time. With inflation expected to decline but remain elevated compared to recent history, portfolios should also include some small exposures to inflation hedges, such as inflation-protected securities and commodities. Portfolios can also benefit from less correlated areas, such as private markets.
On the road to taming inflation, we may not be there just yet, but advisors can help their clients stay on course with well-structured portfolios to ride out the bumps.
Steve Locke is chief investment officer, fixed income and multi-asset strategies, with Mackenzie Investments.