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Is a hawkish Fed tone bad news for equity investment?

By David Burrows

10:35, 17 March 2022

The front of the US Federal Reserve building in Washington, DC.
US Federal Reserve building, Washington – Photo: Alamy

The US Federal Reserve (the Fed) has resurrected Volckerism, according to Salman Ahmed, global head of macro and strategic asset allocation at Fidelity International, which could be bad news for equity investors.

For those not familiar with Paul Volker or ‘Volckerism’, Volker was an American economist who served two terms as the chair of the Fed in the 1970s and 80s under former US presidents Jimmy Carter and Ronald Reagan, respectively.

President Carter appointed Volcker as chair of the Fed in 1979 when the US annual inflation rate was in double digits. Volcker, known to be an inflation hawk, dispensed some strong medicine to the US economy in order to ensure price stability, pushing official interest rates above 20% for a time.

First rate hike in four years

Fast forward to 2022, and as reported in yesterday, Fed chairman Jerome Powell cited four-decade highs in inflation and a tight labour market in the committee’s rationale for its first increase in nearly four years.

Ahmed says the Fed hike yesterday of 25 basis points (bps) was expected, however, the main change was a big shift in the dot plot where the median dot now shows seven hikes for 2022.

Adds Ahmed: “In his comments, Chair Powell indicated a consensus in committee to bring back price stability in the economy, including guidance towards starting QT [quantitative tightening].

“We continue to think the Fed will eventually hike three or four times this year, but the ensuing tightening conditions from a very hawkish Fed will damage growth.”

All in all, Ahmed argues that, given the stagflationary baseline that has been exacerbated by the Russia–Ukraine war, it appears that, based on the Fed’s latest meeting, the focus will be more on inflation fighting, despite the uncertainty created by Ukraine war.

Says Ahmed: “This creates further headwinds for asset markets as the central bank put remains further out of money in this cycle. From an asset allocation perspective, we remain cautious on both equities and credit markets.”

The Fed indicated it remained open to larger incremental increases in the future. The unanimously hawkish tone of the Fed yesterday was in stark contrast to the division on rate increases and the timing of any hikes just six months ago.

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Ukraine conflict causes inflation jolt

Given the uncertainties in the world right now, who is to say whether sentiment won’t have shifted again in another six months?

Tom McGrath, chief investment officer and managing partner at 8AM Global, says the Fed was caught between a rock and a hard place in the March Federal Open Market Committee (FOMC) meeting, especially with events in Ukraine making their task more difficult given the additional jolt to inflation the conflict will cause.

Says McGrath: “They had to regain credibility in this meeting, having been too slow to act last year, and this meant delivering hawkish guidance on rate policy to show they are serious about inflation.”

He adds: “If they did follow through with these rate increases at a time when the economy is slowing, then yes it would potentially cause stagflation – and yes it would be bad news for equities and credit.”

Crucially, where McGrath differs from Salman Ahmedi at Fidelity is that he doesn’t believe the Fed is actually intent on following through with such a hawkish path – he considers that they just had to convince the bond market that they are prepared to.

According to McGrath, “By maintaining the bluff, they can cap long-term bond yields, which are what actually drives the interest rate-sensitive parts of the economy, such as housing and construction, and also the direction of the asset markets.

“Although the Fed cannot admit it now, economic growth and employment remain their primary concern, and they hope [that] by appearing hawkish, long bond yields will remain contained.

“They are walking a tightrope, but there remains a good chance they can fine-tune the outcome and engineer a low-growth environment with inflation trending back to long-term averages, which would be an okay backdrop to be constructive on asset markets.”

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