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Mea Culpa: Fed affirmed higher for longer stance. Fed Chair Jay Powell has in a congressional testimony warned that faster monetary tightening is necessary if incoming data comes in stronger than expected. The hawkish comments triggered a selloff in equities and sharp spike in the 2Y US Treasury yield. But wait, hold on. Didn’t the Fed Chair just opine in February that the “disinflationary process” had begun? A move which triggered hopes of a “goldilocks” environment for risk assets?
This is yet another case of the Fed flip-flopping and one shouldn’t be surprised anymore; you may recall how the central bank also previously pivoted from “Team Transitory” to “Team Structural”. Yesterday’s U-turn marks a continuation of this erratic pattern. The Fed’s apparent indecision on where inflation is heading can be attributed to the following factors:
§ The Fed’s monetary policy framework “Flexible Average Inflation Targeting (FAIT)” was designed to counter disinflationary pressure in an era where inflation fall short of the 2% target. But times have changed and clearly, the framework does not sufficiently address a post-pandemic world where aggregate demand supersedes aggregate supply.
§ Over dependency on incoming macro data which can be volatile, and this leading to short-termism on policy making.
Low likelihood of Fed abandoning 2% inflation goal. The Fed is essentially caught between a rock and a hard place now. With inflation hovering at 6.4%, attaining its 2% target will necessitate the central bank engineering a deep recession. A second, albeit radical, option right now, is for the Fed to abandon its 2% inflation target and push it higher to 3% (perhaps).
A 3% inflation target has its benefits. It brings policy rates further away from the zero lower bound (ZLB) and in turn, provides the central bank with greater ammunition to fight unemployment through rate cuts in the future.
But in reality, a more likely outcome is for the Fed to stay put and keep its inflation target at 2%. After all, changing a well-entrenched target will subject the Fed to credibility risks and we believe the central bank will not take that step.
Twin Headwinds: Rising cost of capital and rising margin pressure. Rising bond yields translate to higher costs of capital and this will be a significant headwind for companies that are highly leveraged. As we have recently highlighted in CIO Perspectives: Stay with Quality Amid Higher for Longer Rates (dated 23 Feb), the prevalence of sticky wages will translate to margin pressure for companies, particularly the more labour intensive ones. So, highly leveraged companies with thin operating margins should brace for volatility ahead.
Quality Plays: An enduring strategy for challenging times. To navigate the challenging environment of persistent inflation and higher for longer policy rates, we reiterate our strategy of staying with “Quality Plays”. This is the year for bottom-up stocks selection, a year where selecting and staying with winners possessing strong corporate fundamentals will reap dividends. As Figure 1 shows, quality plays have been outperforming the broader market in a rising rates environment and we expect this momentum to persist.
Figure 1: "Quality Plays" outperformance
Source: Bloomberg, DBS
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