The Federal Reserve has held its February FOMC meeting. As expected, the Fed signalled that a March rate hike is very likely, with the post-meeting statement stating that “it will soon be appropriate to raise the target range for the Federal Funds rate”. Chairman Powell reinforced that at the post meeting press conference by stating that “the US economy no longer needs sustained monetary support”. However, the Fed was vague in terms of its plan on the reduction of balance sheet and did not disclose any detail on timing.
Given the rise in bond yields and fall in equity indices, the most pressing question is whether the current correction is a “buy the dip” opportunity? We are more cautious on this correction than past corrections in 2021. In other words, the correction has to be significantly worse than the 5.2% fall experienced in the Delta outbreak in mid-2021 to justify an aggressive rotation into equities.
The most fundamental reason for our cautiousness is the outlook on US inflation. Similar to most investors, we believe US inflation will moderate over the next 12 months as some of the temporary, supply-side dislocations dissipate. However, we are not confident that US inflation will moderate sufficiently, say to 3.0%, to allow the Fed to turn more dovish and to signal an end to interest rate increases. The risks to US inflation and hence US interest rates are firmly biased toward the upside. While the Fed is not necessarily hawkish, it may conclude that it is more optimal to raise the Federal Fund rate aggressively in 2022 to “nip inflation in the bud”, rather than playing catch up in 2023.
Another source of uncertainty is the Fed’s plan for balance sheet reduction. It has indicated that it would start the process earlier than history suggested but has not disclosed any details. For instance, the Fed’s balance sheet is currently around $8.8 trillion, compared to a pre pandemic level $4.1 trillion. A 50% reduction in the Fed’s balance sheet is unlikely but is a 20% reduction possible? Likewise, whether the reduction in balance sheet takes, say, 12 months rather than 30 months will make a huge difference. The simple answers to both questions are no one knows! Until the Fed provides more guidance on those issues, both bond and equity markets will likely remain on edge and will be volatile.
The second reason for our conservatism is the outlook for corporate earnings. Most developed equity markets staged an impressive recovery in earnings in 2021. While corporate earnings are still expected to grow in 2022, the pace of increase will likely slow according to sell side analysts. This loss in momentum in earnings growth may accelerate over the next 12 months. Lower economic growth, due to both the dissipation of the beneficial effect of the reopening of economies and the impact of higher interest rates, is one factor. In addition, rising input costs and wages (especially in the US) represent another potential headwind for corporate profits. So far, corporates have been able to pass on the input price increases to consumers who have hungrily bought up goods as they emerged from lockdowns. This is unlikely to last forever.