Stocks fell last week as higher interest rates weighed on valuations. Stocks have now fallen for five weeks in a row.
For the past decade, the markets were supported by a “Fed put”. This refers to the fact that whenever markets fell, the Fed lowered interest rates and (re)started Quantitative Easing, which quickly stabilised markets.
The Fed could do this because inflation was contained.
The inflation picture has now changed and, as a result, the Fed put has morphed into a “Fed call”. This means that if the market rallies too much, the Fed will increase interest rates more than expected, thus arresting any market rally.
The Fed is doing this because higher equity prices, which support consumer confidence, would make restraining demand and prices more difficult.
“Don’t fight the Fed” is an old investing rule that advises investors to align their portfolios with what the US central bank is doing. At the moment, the rule calls for caution. Long-term interest rates have already increased, but it may well be that they need to increase further to bring inflation back under control.
If the Fed becomes serious about inflation, we would not be surprised to see rates in the 4-5% range in the US next year. Rates at these levels would probably bring about a typical recession bear market, when stocks fall 30-40%.
Stocks have already fallen 14% this year, but we do not believe this decline fully discounts the risk of a Fed-driven recession. We therefore continue to position the portfolio more defensively than usual. Technology stocks ($XLK), and Growth stocks more generally ($VUG), are particularly vulnerable to higher rates, in our view, and we thus continue to prefer Value stocks ($VTV).
Value stocks look cheap: bank ($XLF) and Energy ($XLE) stocks, for example, trade at distressed valuations. At the same time, it has to be acknowledged that the risk of a significant sell-off affecting all parts of the market is higher than usual, and will remain so as long as the Fed is behind the curve. We will try to outperform the index while trying to get to the turning point in the markets (which we expect to occur in about 12 months) without excessive damage to the portfolio.
$HR (Healthcare Realty Trust Inc), $RNR (RenaissanceRe Holdings Ltd) and $VICI (VICI Properties Inc) were replaced by $SAN.MC (Banco Santander SA), $SAN.PA (Sanofi) and $KB (KB Financial Group Inc) .