This year has started with a lot of volatility in bond and equity markets due to one main question: how quickly will central banks normalize policy this year? In particular, investors are keenly focused on the U.S. Federal Reserve policy changes this year. This has resulted in more than 25bps increases in the 10 year yield, almost 20bps increase in the 2 year yield, and negative returns in equity markets, especially technology companies. We do believe the Fed has changed direction and is now focused on normalizing its policy, due to 3 main reasons: a strong economy, very strong labor market, and high inflation

The economy is strong, with the U.S. economy likely growing 7% in the 4Q of last year. While the variant Omicron might depress services activity early this year, the Fed is comfortable that the economy has shown to be less and less exposed to the pandemic as medical solutions have improved and people and businesses have adapted.

The labor market is extremely strong, with the unemployment rate ending the year at 3.9% in December, below the Fed’s estimate of normal which is 4%. By many metrics, like record high open positions and quits rates, this is the strongest labor market we have seen in decades. As a result, the Fed believes we are at or very close to their maximum employment goal. Inflation is high and sticky inflationary pressures are increasing. Headline CPI inflation likely ended the year above 7%, with the core above 5%. While there is some confidence inflation will moderate this year as commodity prices stabilize and goods prices decelerate, there are also clear signs that there are sticky elements to inflation too. Rental inflation has been increasing at the fastest pace in 3 decades and wage growth is rising 5.8% year over year. As a result, the Fed minutes showed inflation is now considered the main risk to the Fed’s mandate.

As a result, the Fed is likely to normalize policy this year – and much more quickly than a decade ago after the financial crisis. Investors are now expecting 4 steps towards normalization all happening this year instead of spread out over 3 years. This quicker timetable than expected is due to a much stronger economy than after the financial crisis – and with higher inflation risk. The steps are:

– The Fed is set to end QE (or its new purchases of bonds) in March.

– The Fed is set to start raising interest rates in the first half of the year, either in March or June.

– The Fed is set to continue raising interest rates another 2-3 times, for a total of potentially 4 hikes.

– The Fed is set to start shrinking its balance sheet in the second half of the year.

Markets are now better pricing in this timetable, but bond yields may still move higher during the year, especially mid to long-end yields, leading to steeper curve. Two main questions remain:

– What is the pace of balance sheet shrinking? It is likely to happen double as fast as last cycle.

– How high will the Fed raise interest rates? The market believes only to 1.6% vs. the Fed believes over 2.1% by end of 2024.

What are the implications for investors? Careful with interest rate risk. This should be a second difficult year for fixed income returns, so investors should focus on losing less by shortening duration and focusing on High Yield credit over investment grade.

Avoid expensive areas of the market. Now that the Fed is raising rates, valuations matter again. The sell-off this year has been heavily focused on the most expensive, high growth areas of the equity market like software, EVs, new IPOs. It is important to think about selecting companies based on the price we’re paying for fundamentals, especially within the growth style. Add less expensive areas of the market, like the value style (banks, industrials) and non-U.S. markets (China, Europe, Japan). Given how well growth and the U.S. have done, portfolios are likely heavily concentrated on a few companies, so taking profit and diversifying is a good strategy. Focus on alpha over beta this cycle. Given the high valuation starting point for equities and bonds, returns will be harder to come by at the index level. In addition, index investing is actually dangerous given interest rate and concentration risk. The good news is there is a lot of valuation dispersion beneath the surface by company, style and region. When money is no longer cheap, the companies with good fundamentals and reasonable valuations are set to outperform. How you invest is as equally important as investing.