Markets are currently pricing in a good chance that the first policy rate increase will come from the Federal Reserve (Fed) in March 2022. So how should equity portfolios enter a tightening cycle?
As discussed in more detail earlier, stocks historically do not appear to have been upset prior to the Fed’s tightening cycle. Other things besides monetary policy affect stocks, but stocks are not destined to be underperforming leading to higher interest rate. Stocks seem to be getting nervous after the first rally, perhaps for good reason since the last three outing cycles ended in recession.
Analyzing what has worked historically during price-raising cycles is complicated by the lack of a large number of cycles and the paucity of data available to analyze the performance of ‘legacy’ history. For this reason, this analysis will combine the study of history with some insights into the current environment.
During these cycles, dividend yield and higher dividend growers have generally had a good track record. This performance makes some sense because dividend payers, especially dividend growers, tend to be stable companies. Additionally, dividend stocks are a copy of a value investment. Value has a long history of strong performance but has been underperforming for a very long time recently. Valuations should act as a tailwind for valuing stocks as they are being sold at the lowest valuation compared to growth stocks since the tech bubble. In addition, higher returns should benefit the value of the shares, all other things being equal. The risks are that value stocks tend to be more vulnerable to economic downturns, and growth stocks have shown better resilience during the Covid-related business turmoil.
Another area worth focusing on is quality inventory. Quality stocks tend to be defined as having a high return on equity (ROE) and less debt. Quality managed to perform well over previous hiking sessions on average. Additionally, quality has been shown to yield high risk-adjusted returns both in the United States and globally. Investing in quality also puts you in good company as there is evidence that Warren Buffett used high quality stock as part of his investment formula to achieve higher returns. The quality risk is that risk appetite continues to spread, and quality performance must be substandard in this situation. If the Fed’s increases cause some concern about a policy error leading to a recession, quality should benefit.
Omicron and any other future variables add another level of uncertainty about economic activity and any future Fed policy actions. Assuming Omicron remains highly contagious but does not result in as many hospitalizations as previous virus strains, the Fed should be on track to rally in March. Consumer mobility does not appear to be significantly affected by increased infection, but this needs to be monitored. Friday’s strong December jobs report will provide another hint that markets should continue to anticipate a Fed hike in March.