Markets are currently anticipating a good chance that the first Federal Reserve (Fed) rate hike will come in March 2022. So how do you position equity portfolios before a tightening cycle?
As discussed in more detail previously, stocks historically do not appear to be in trouble before a Fed tightening cycle. Besides monetary policy, there are other factors that impact stocks, but stocks are not meant to perform poorly before rates rise. Stocks seem to get more nervous after the first rise, perhaps for good reason as the last three bulls cycles have ended in recession.
Analysis of what has historically worked during cycles of rising rates is complicated by the lack of a large number of cycles and less data available to analyze performance in the “oldest” history. For this reason, this analysis will combine a study of history with some reflections on the current environment.
During these cycles, higher dividend-paying stocks and dividend producers have generally had a good track record. This performance makes sense since dividend payers, especially dividend producers, tend to be stable companies. Additionally, dividend-paying stocks are seen as a version of value investing. The stock has a long history of strong performance, but has recently underperformed for quite a long time. Valuations should be a positive wind to value stocks as they are selling at the lowest valuation relative to growth stocks since the tech bubble. In addition, higher yields should benefit value stocks, all other things being equal. The risks are that value stocks tend to be more exposed to economic downturns and growth stocks have shown better resilience during Covid-related business disruptions.
The other area of interest is that of quality stocks. Quality stocks tend to be defined as having a high return on equity (ROE) and less leverage. Quality has managed to perform well over the past average hiking cycles. Additionally, quality has been shown to generate high risk-adjusted returns in the US and globally. Investing in quality also puts you in good company, as Warren Buffett has been proven to use quality stocks as part of his investment formula for superior returns. The risk to quality is that an aggressive risk appetite continues to set in, and quality should underperform in this situation. If the Fed’s hikes raise concerns about a policy error leading to a recession, quality should benefit.
Omicron and all other future variants add another level of uncertainty regarding economic activity and any future Fed policy action. Assuming Omicron remains highly contagious but doesn’t result in as many hospitalizations as previous strains of the virus, the Fed should be on track to increase in March. Consumer mobility still does not appear to be significantly affected by the increase in infections, but this will need to be monitored. A strong December jobs report on Friday would provide another clue that markets should continue to expect the Fed to take off in March.