Rate hikes are back—what can investors expect?
Risks are rising, but we think the global economy should withstand the challenges ahead.
Our Top Market Takeaways for March 18, 2022.
Ready, set, liftoff
After some initial indigestion, stocks soared as the Fed lifted off with its first rate hike since 2018 and Russia made moves to avoid defaulting on its debt payments. Heading into Friday, the S&P 500 had wrapped up (and closed out St. Patrick’s Day) with its largest three-day green streak since November 2020. The Stoxx Europe 600 was less than 1% off the levels seen just before Russia invaded Ukraine. Even downtrodden Chinese stocks saw a boost after policymakers pledged support as lockdown risks mount.
Yet more notable has been the swift and large move higher in rates. So far this month, 2-year Treasury yields have jumped a staggering +48 basis points (bps) to 1.92% (on track for the largest monthly leg higher since 2008!), while the 10-year has popped +35 bps to 2.17%.
The upward march comes as the Fed solidified its more aggressive stance at this week’s meeting—it now plans to hike rates quickly and consecutively until something (such as a growth threat that derails demand) tells it not to. With inflation soaring and a strong labor market, economic conditions are inconsistent with still emergency-era levels of support.
The latest forecasts show the median FOMC member expects to bring the central bank’s policy rate to 1.9% by the end of the year, implying a 25 bps hike at each of its remaining six meetings (with a 50 bps still on the table). And it plans to keep going in 2023 until the fed funds rate reaches 2.8%—above the 2.4% it estimates is the “friction zone” where borrowing costs start to pinch growth.
This hawkish path showcases how a high-inflation, slowing-growth environment presents a challenge for central bankers—hike rates too much, and you risk exacerbating unemployment; do nothing or cut rates, and inflation could spiral further. At the press conference, Chair Powell acknowledged that the risks are growing around stagflation, aka economic stagnation (with slow growth/rising unemployment) and high inflation. The last time we saw such an environment was the 1970s, and it was a mess: The economy and markets were plagued by widespread food and energy shortages, soaring interest rates and a lingering selloff.
Landing the plane through effective policy won’t be without turbulence, and central bankers have a narrow runway to get it right. To gauge the path forward, it’s worth dissecting both sides of the inflation-growth coin.
Navigating high inflation and slowing growth
With oil prices above $100/barrel, no clear end in sight to the Russia/Ukraine crisis, and now rate hikes underway, are we falling into another stagflationary trap?
Risks have undoubtedly risen, and higher inflation and slower growth (compared to expectations at the start of the year) seem to be on the cards. But the price action this week suggests that investors are finding solace in the underlying strength of the U.S. economy. While the expansion may be dented, we do not believe it’s been derailed.
Let’s break it down.
The bad news:
Before the current crisis, inflation across the world was already at multi-decade or record highs. As we face the uncertainty of war, it looks like a longer road for inflation to meaningfully moderate, even as consumers shift their spending back toward services from goods, and base effects come into play. At this week’s meeting, the Fed said it expects core inflation in 2022 to round out at 4.1%, notably higher than the 2.7% it expected in December—and it anticipates inflation to stay above 2% through 2024.
The rise in commodity prices is even more problematic for Europe. Energy had already accounted for half of the region’s rise in consumer prices in 2021, and it sources 20% of its energy consumption from Russia.
The good news:
In the United States, while market-based measures of long-term inflation expectations have jumped as crude prices have rocketed (10-year breakevens are near their highest since data starts in 1998), it’s worth noting this is largely due to expectations for inflation to be more elevated over the next year or two, rather than permanently. Consumers seem to agree with this sentiment: Expectations for inflation over the next three years are notably lower versus one year ahead. This suggests that Americans believe they can weather the storm of higher prices—a prescient point for those worried about a wage-price spiral.
The bad news:
Price pressures, higher interest rates, and uncertainty around commodities and supply chains are all conspiring to pressure growth. Since the start of the year, economists have downgraded their growth expectations for the year—with the most acute pain expected in Europe.
The good news:
Growth looks likely to slow from here, but it’s critical to remember that the backdrop is still one that is fundamentally healthy. Across the United States and Europe, consumers are on strong footing. U.S. household wealth is 13.5% higher than pre-pandemic levels (suggesting ample wiggle room for higher fuel and energy costs), debt servicing costs remain low, and the labor market grows tighter by the month (the U.S. unemployment rate is at 3.8%, and in the Eurozone, it’s the lowest it’s ever been). Similarly for corporates, margins are still near record highs, earnings revisions are trending higher, and plans to invest in capex and return value to shareholders have increased.
Further, governments in Europe have signaled their intention to lend support (such as through EU bond sales to fund energy and defense spending), mitigating at least some of the economic strain.
Calibrating the path forward is wrought with uncertainty, but the resulting volatility also brings new opportunities to the fore.
Higher inflation and interest rates provide a compelling case to get out of cash and consider other liquidity options and the role of bonds in your portfolio.
Further, roughly one-third of S&P 500 companies are currently in bear market territory (more than 20% off their 52-week highs)—and some stocks look too black and blue than their fundamentals would otherwise merit. Quality companies (those with healthy balance sheets, demonstrated ability to compound earnings, and robust ESG scores) are broadly trading at a discount, and we see opportunity in such stocks across sectors.
Your J.P. Morgan team is here to discuss what strategies might be right for you.
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