How to play a potential Fed pivot

Inflation expectations are being wound back in financial markets following signs that US inflation is cooling. The US Federal Reserve may ease off hefty interest rate hikes next year or even cut rates to avoid a hard economic landing, though recession in the US may be inevitable.

The annual inflation rate in October slowed for a fourth month to 7.7% in October, the lowest rate for several months and below economists’ forecasts of 8%.¹ Following the release of the lower-than-expected inflation data, the US Federal Reserve is now expected to slow the pace of its rate hikes. Financial markets are predicting a 50 basis points increase at the Fed’s December 13-14 meeting, and the Fed Funds Rate is forecasted to peak at 5% in June.²

But the possibility of a ‘US Fed pivot’, that is, a pause or reversal of rate hikes, depends on inflation continuing to moderate in the US. Signs are emerging that pressure on consumer prices could ease. Oil costs have been falling, down from around US$120 a barrel midyear to around US$85 to US$90 a barrel in November.³ If that drop is sustained next year, that will put downward pressure on consumer prices, both directly in terms of what consumers pay for petrol, and indirectly by reducing the cost of goods such as food which need to be transported.

But we don’t know exactly what will happen to inflation and what the US Fed will do either in December or in 2023. If inflation moderates without any major adverse growth implications, and the US economy has a ‘soft landing’, then it’s likely to be constructive for equities and corporate bonds.  But if economic growth stalls, and the US experiences a hard economic landing, then share prices could stall and government bonds rally.

Questions over hard or soft landing

The possibility of a US recession is weighing on financial markets and investors. While the US central bank may ease back on rate rises next year, the central bank has already done a lot of rate hiking this year. Higher interest rates will inevitably lead to a slowdown in consumer spending and economic activity, perhaps even an economic contraction.

In the IMF’s latest World Economic Outlook 2022,⁴ the current slowdown in global economic growth is described as being both broad-based and sharper than expected, with the worst yet to come. The IMF is predicting economic growth of just 1.0% for the US in 2023, and 0.5% in the European area, and the forecaster says one-third of the world economy will likely contract this year or next amid shrinking real incomes and rising prices.⁵

“The three largest economies, the United States, China, and the Euro area will continue to stall,” the IMF says. “Overall, this year’s shocks will re-open economic wounds that were only partially healed post-pandemic. In short, the worst is yet to come and, for many people, 2023 will feel like a recession.”

Hard landing will be good for bonds

If such a hard landing results, and the US economy does grind to a halt next year, as the IMF suggests, share prices could suffer. That’s because falling business activity could lead to lower company earnings and consumer spending and surging unemployment. If such a ‘risk-off’ environment eventuates, riskier assets such as shares are likely to fall in price. However, the price of quality fixed income assets such as government bonds is likely to rise as investors flock to safer assets.

In such a scenario, investors may consider the GGOV U.S. Treasury Bond 20+ Year ETF – Currency Hedged , which provides  exposure to high-quality US Treasury bonds which historically have been among the better performing assets during US recessions and periods of global economic weakness. Investors will also benefit from a regular income from a portfolio of high-quality, long-dated US government bonds.

A soft landing is still possible

However, no one knows what will happen to the US economy in 2023, not the IMF and perhaps not even the US Federal Reserve. It all depends on future inflation numbers.

If inflation does continue to trend down, then the US central bank may not raise interest rates much further. Economic growth may slow in the US, but not stall. In such a soft-landing scenario, equity markets may perform relatively well and growth shares, including technology shares, could rebound if as markets think interest rates have peaked.  In this scenario, other growth and higher risk assets such corporate bonds may potentially deliver good returns for investors and offer attractive portfolio diversification.

Exchange traded products such as NDQ Nasdaq 100 ETF  allow investors to gain exposure to some the world’s largest and most innovative technology companies including Apple, Amazon, and Google. If investors don’t want to take on the risk of a rising Australian dollar eroding returns on their investment, the HNDQ Nasdaq 100 ETF – Currency Hedged  seeks to minimise the effect of currency fluctuations on returns.

Some fixed income investments may also do well and allow investors to reap a regular income. The CRED Australian Investment Grade Corporate Bond ETF  gives investors the opportunity to earn attractive regular income, paid monthly, from a portfolio of investment grade Australian corporate bonds.  Those returns could be expected to be higher than term deposits, government and composite bond exposures.

As always, it is important for investors to take a long term view and for their portfolios to remain well diversified. These ETF options allow investors to construct their portfolios with a view to economic conditions in the world’s largest economy and allocating to international shares and bonds to deliver diversification.

References:
1. Consumer Price Index Summary – 2022 M10 Results (bls.gov)
2. Source: Bloomberg, BetaShares. As at 25 November 2022.
3. https://www.eia.gov/dnav/pet/hist/RWTCD.htm
4. https://www.imf.org/en/Blogs/Articles/2022/10/11/policymakers-need-steady-hand-as-storm-clouds-gather-over-global-economy
5. Policymakers Need Steady Hand as Storm Clouds Gather Over Global Economy (imf.org)