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Market Rotates to Value as Fed Turns Hawkish

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What You Need to Know

  • The pace and number of interest rate increases will be data-driven; Fed Chairman Jerome Powell has confirmed as much.
  • Although consumers are feeling the spike in inflation, there is still significant pent-up demand.
  • Plentiful jobs, higher wages and strong home prices all point to above-trend growth, perhaps as soon as Q2.

Federal Reserve Chairman Jerome Powell’s tone turned decidedly more hawkish this week, indicating that the Fed will be much more willing to raise interest rates faster to rein in inflation. I have been saying for some time that the pace and number of rate increases will be data-dependent in 2022; Powell confirmed that the Fed plans to be “humble and nimble,” led by the incoming data and the evolving outlook.

U.S. employment data has consistently shown that we have many millions more job openings than there are unemployed people, and quit rates are rising, indicating that people feel comfortable that they can secure another job. With a tight job market and wages at decade highs, Powell said that he believes there is room to raise rates without threatening employment. 

Any way you look at it, inflation is hot, not just in the U.S., where it is rising at the fastest rate since the early 1980s, but globally. In December, Eurozone inflation rose 5% year on year, but the European Central Bank is reluctant to raise interest rates. In the U.S. and globally, consumers are feeling it — at the gas pump, the supermarket, the repair shop, the vet, hotels and big-box stores. 

Expectations for multiple rate increases sent the U.S. 10-year Treasury yield soaring from 1.34% in early December to a mid-January high of 1.87%. The rapid surge rattled equity investors already concerned about the omicron spike and inflation. Despite the drop in equities this month, the Fed will be driven by incoming data, not the market; current declines in no way match or surpass the gains we saw in 2021. 

Though investors have many concerns right now, it’s important to remember that we still have significant pent-up consumer demand. In recent weeks, J.P. Morgan Chase CEO Jamie Dimon said consumer balance sheets have never been in better shape; their debt-service ratios are the best since the bank started keeping records 50 years ago. According to Dimon, consumers have $2 trillion in more cash in their checking accounts than they had before COVID, and are spending 25% more today than before the pandemic. Dimon said he believes the U.S. is headed for the best economic growth in decades. Adding to the positive consumer picture are recent statements from airline and hotel companies about robust demand for bookings.

We’re seeing a notable rotation into value and cyclicals, with many overvalued tech stocks taking it on the chin. In my portfolio, I remain focused on sectors such as financials and energy, as well as reopen names that will benefit from consumer spending, and am underweight growth — staying clear of companies that don’t have real earnings growth or attractive valuations. At the same time, I’m keeping my eye out for strong companies on sale across several sectors, such as health care, tech, energy, and restaurants/reopen names. 

Mixed Economic Picture

Earlier this month, the market jitters about inflation were confirmed with news that the consumer price index (CPI) rose 7% year on year in December, which was the largest 12-month increase since mid-1982. The producer price index, meanwhile, rose 9.7% year on year. Wages, too, are rising rapidly: December average hourly earnings rose 4.7% year on year. 

Omicron is having an impact, which I view as temporary. Markit PMI slowed to an 18-month low, posting 50.8 in January, down from 57.0 in December. Markit reported that both manufacturing and service sectors reported broad-based slowdowns as the steep spike in omicron cases contributed to ongoing supply chain problems and labor shortages. On the bright side, demand growth remained more resilient, with new orders for goods and services rising strongly.

The latest Institute for Supply Management’s Manufacturing Report on Business and Services Report on Business surveys showed that economic activity in both sectors grew for the 19th consecutive month

All of the six biggest manufacturing industries including chemical products, fabricated metal products, computer and electronic products, food, beverage and tobacco products, transportation equipment, and petroleum and coal products registered moderate to strong growth in December.

On the service-sector front, the Services PMI exceeded 60% for the 10th consecutive month, though employers continue to struggle to replenish inventory, with the industry sentiment index remaining in the “too low” territory through December. 

Allocating Portfolios in Times of Uncertainty

In the current uncertain environment, I am maintaining my focus on the fundamentals: companies with strong revenue, real earnings growth, strong margins, balance sheets and free cash flow. We always advise investors to avoid getting seduced by high fliers; though momentum is exciting to watch when stocks are rising, there’s no way to understand how much you stand to lose when a company has poor earnings or valuation support.

For tech names, I look for large total addressable markets with real earnings, at attractive valuations — for instance, networking companies that will benefit from enterprise IT spending, or semiconductor manufacturers that serve the auto industry.

Financials tend to be beneficiaries of a rising rate environment, as a steeper yield curve contributes higher profitability for lending.

The big six U.S. banks have reported earnings; highlights have been strong revenue in investment banking, investment management, loan growth, net interest income contribution and better return on tangible common equity. Earnings were partially offset by elevated expenses. Some names have navigated this better than others, and we continue to be selective in this sector, although remaining overweight.

We are also overweight in the energy sector, focusing on companies that can capitalize on the higher-priced environment by either investing in added capacity or developing new energy alternatives.

In addition to these investments in the future, some energy companies are returning cash to shareholders: Sales, EPS, buybacks and dividends have all increased over the past 12 months for the sector. I am seeking out companies with successful restructurings behind them, solid top-line growth and pricing power. If the Ukraine situation heats up, expect oil prices to soar.

Given my belief that consumer demand will continue to be strong and the economic recovery will stay on track, I expect services such as airlines, restaurants, travel and leisure to outperform, and maintain holdings in select reopen names. 

This year will be more challenging for investors than 2021, as the Fed pulls out all the stops to put the brakes on inflation and normalize policy.

Though GDP will take a hit in the first quarter due to omicron, from a consumer perspective, jobs are plentiful, wages are higher and home prices are strong, which support demand and indicate we are still headed for above-trend growth, possibly as early as Q2. 

Stephanie Link is chief investment strategist and portfolio manager at the national wealth management firm Hightower Advisors LLC. She leads the firm’s Investment Solutions Group, which specializes in outsourced chief investment officer services, model portfolios, separately managed accounts, investment research and due diligence for Hightower Advisors LLC. Follow Stephanie on LinkedIn and Twitter @Stephanie_LinkRead her regular market insights here.


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