The September Federal Open Market Committee (FOMC) meeting was clearly hawkish. The Fed noted the improvement in the sectors most impacted by Covid-19, and acknowledged the substantial progress towards achieving employment goals while noting that it considers inflation as “elevated”. We expect tapering to be announced at the November meeting unless there is a material change in the data. The message was as expected with the Fed doubling down on their stance conveyed at the Jackson Hole Economic Symposium in August.
Of interest at Jackson Hole, was Powell’s comment; “The timing and pace of the coming reduction in asset purchases will not be intended to carry a direct signal regarding the timing of interest rate liftoff, for which we have articulated a different and substantially more stringent test”.1 This reiterated his position on disconnecting the taper timing from the timing of any future rate hikes. Tapering signals normalisation in growth which in turn leads to normalisation in interest rates, and hence future hikes from their current levels. The timing of the hikes is the big question.
In the September meeting, FOMC members were split between zero and at least one hike in 2022, and were projecting three hikes in 2023 and 2024. The Fed is trying to maximise employment by keeping rates at record lows to spur demand and trying to solve a problem that is essentially not theirs to solve. Issues around distributional equity have been generations in the making and Fed thinking they can sustainably solve them via lower interest rates during half a business cycle, might become an issue. Especially if, in letting the economy run hot, they mis-step and let it (and inflation) run too hot for too long.
Figure 1: United States Consumer Price Index (CPI)
For investors, higher inflation even if transitory can pose significant downside risks. Equity investments generally face additional headwinds in inflationary environments. In this environment the equity risk premium remains intact, however valuations are now looking frothy. Investors also need to be wary that risks to long growth positions are increasing, with inflation being one source of increased risk in equity exposures. In such a scenario, more defensively styled equity exposures may better position investors for future bouts of volatility. Equity style factors such as Quality & Low Volatility have provided positive real returns during rising inflation.
In multi-asset portfolios, investors have had the cushion provided from bonds. That cushion is provided by the mechanism of yields being able to move lower. However in the current low yield environment, there is very little cushion. The Fed and other central banks have intimated that they are willing to let inflation run hot so interest rates and yields can be expected to remain anchored. This means bond investors additionally need to manage the interest rate sensitivity (duration) of their investments. That is where assets like Floating Rate Notes can potentially benefit investors providing an additional source of yield without the duration risk.
1 Jerome Powell, Jackson Hole Economic Symposium, August 2021.
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