How to position portfolios as the Fed presses pause

The Fed delivered its hawkish pause. The dot plot has maintained the previous projection for one more rate hike this year. And 50bps of rate cuts were wiped out of the 2024 projection. There is the higher for longer view coming clearly from the Fed. But is it credible? If not, why not? And how can investors position for this? I think investors should consider fading the Fed, and fading equity market rallies.

The risk of recession is very high.

The prevailing consensus is for a soft landing. But the labour market resilience that has been the hallmark of the soft-landing narrative is giving way. Job opening data is collapsing, solid-looking jobs growth is being revised lower, and the unemployment rate is moving higher. Keep an eye on the Sahm rule – an indicator that measures the rate of change of the unemployment rate relative to recent lows. It is moving higher. Not a good sign.

Chart 1: Job openings are collapsing – and that tends to lead growth lower.

Credit is decelerating and the manufacturing sector is well below trend. Not to mention the inverted yield curve – an historically reliable indicator for recession, is pointing to the risk of recession in the next twelve months being higher than even the GFC.

Chart 2: The inverted yield curve is indicative of a very high risk of recession over the next year.

Weak growth, weak earnings.

The US S&P500 earnings growth was weak in absolute terms in Q2. But forward expectations are remarkably strong. This looks heroic, set against a slowing economic backdrop. More negative earnings growth results seem more likely.

Chart 3: Earnings growth is negative and could slow further over coming quarters.

It seems plausible that actual earnings could disappoint the forward expectations. And that is a catalyst for a repricing of stretched valuations. The market is looking increasingly vulnerable to negative news given the move to price in a soft landing. We think being underweight equities makes sense now.

Yields are pricing this time is different.

The Fed’s dot plot moved the median projection for the Fed Funds rate 2024 half a percent higher than the June dots – with only two rate cuts priced over the year. The market is pricing three rate cuts. That is a remarkably positive outlook and a classic example of markets pricing this time being different.

One more hike is priced for this year. Its possible the Fed will get this in, although the negative trend for data suggest the Fed is on hold.

Treasury yields are attractive in an outright sense. But it is the prospect for significant rate cuts that make this such an important asset class. We have been overweight short-dated government bonds. Longer duration is beginning to look attractive.

Currency will matter.

The US dollar has rallied recently as yield differentials have improved in favour of the global reserve currency and the economy has proven resilient. I think this could persist. The hawkish Fed should support the USD in the very near term. Beyond that, a weakening economy will likely boost safe-haven flows into the US Treasury market and the USD. That spells trouble for the AUD. From an Aussie investor perspective, I’d recommend being under-hedged still. For USD investors, consider lifting hedge ratios.

Chart 4: Yield differentials favour the USD – and risk sentiment could weaken the AUD.

What is the risk to the outlook?

I think the risks for the outlook are skewed to the downside. But inflation could pick up. The labour market could strengthen. The negative economic trends could stabilise and elevated rates could prove to be less restrictive thank I expect.

In that scenario, holding but not adding equity exposure, while bar-belling the portfolio with cash, could be an option. Keep bond exposure short duration and (and short spread-duration) – this will provide some resilience against a downturn, but provide exposure to any potential equity upside.

Time to focus on portfolio resilience.

The Fed is most likely very close to or at the end of its rate hike cycle. Historically, this has meant rates are restrictive and the economy starts to slow. That usually means downside risks for equities and upside risks for bonds. I think that is likely to happen this time – and so being somewhat underweight equities and overweight government bonds make sense. But investors could also choose to barbell their portfolio to build resilience, if they expect equities can continue to grind higher. The most critical action for investors is to consider your portfolio, consider the outlook, and make sure you are comfortable with the level of risk you are taking given your expectations.