The Hiking Roadmap
- The key theme as we transitioned from 2021 to 2022 was the hawkish pivot across developed market (DM) central banks, as inflation remains uncomfortably high in many parts of the developed world.
- While there are many reasons to believe inflation should moderate by the end of 2022, market participants have rapidly moved to price in around seven rate hikes from the Federal Reserve (Fed) by the end of this year, a reflection of their beliefs that the Fed will act to contain high and persistent inflation.
- We explore what happened in the macroeconomic landscape during previous rate hiking cycles of the 70s, 80s and 90s and explain why risk assets generally delivered positive returns across Fed rate hiking cycles. Where returns were negative, we attribute them to different starting macro conditions.
- Navigating volatile waters is never a pleasant experience, but if we use history as a guide, the consistent lesson delivered is steady hands will ultimately prevail.
The key theme as we transitioned from 2021 to 2022 was the hawkish pivot across DM central banks, as inflation remains uncomfortably high in many parts of the developed world.
While there are many reasons to believe inflation should moderate by the end of 2022 (easing of supply chain bottlenecks and hence goods inflation is one of them), market participants have rapidly moved to price in around six Fed rate hikes by the end of this year, a reflection of their beliefs that the Fed will act to contain high and persistent inflation.
The market pricing of rate hikes has pushed up yields, with the 10 Year UST yield hovering around 2%. At current levels, it is now 50bps higher than where it started the year, led predominantly by an increase in real yields. This has led to a second-order impact on risk assets, and so far we have seen pockets of equity markets with high valuations derating the most. On a year-to-date basis through February 9, the U.S. Technology Index is down close to 6% while the S&P 500 is down ~3.6%. The VIX also soared from 17 all the way to 32, before stabilizing at around 20 for now.
We explore what happened in the macroeconomic landscape during previous rate hiking cycles of the 70s, 80s and 90s and explain why risk assets generally delivered positive returns across Fed rate hiking cycles. Where returns were negative, we attribute them to different starting macro conditions and compare them to what we are seeing today.
Exhibit 1: U.S. real rates year-to-date trajectory
The Macroeconomic Backdrop
Curve Shape (3m10y): The most consistent observation from Fed hiking cycles since the 1970s is yield curve flattening. The 3 month - 10 year (3m10y) yield curve bear flattens by an average of 50bps during hiking cycles, led predominantly by front-end rates rising. We use the 3m10y U.S. term spread as it is the Fed’s preferred metric on predicting future recessions after years of dedicated research on this topic. Is the flattening of the yield curve a concern for risk assets? The math proves it is not. Calculating betas of risk assets to curve flattening using data across all rate hiking cycles starting from the 1990s yielded sensitivities that were very close to zero. The reasons why are two-fold. First, while the curve generally flattens as rate hikes aim to keep the economy from overheating, it is mostly still upward-sloping at the end of the rate hike cycle. Second, the growth environment remains robust through the hiking cycles, which should impact risk asset performance more than worries about yield curve flattening.
Growth (US New Orders Purchasing Managers’ Index (PMI)): We choose to use the new orders PMI index to define the growth cycle as it is a purer expression of forward-looking demand and is not as subject to distortions as is the headline PMI, where longer supplier delivery times due to supply chain issues can artificially boost the headline PMI number. The Fed has historically hiked into strength. Across all three decades, the Fed, on average, was able to hike rates to counteract overheating without stifling growth. New orders PMI levels have, on average, stayed above 50 (expansionary territory) during all rate hiking cycles since the 1970s. It was only in the 1980s, when the Fed was fiercely fighting inflation, that average new orders PMI levels were below the historical average of ~55, but those were largely driven by the earlier hiking cycles between 1980 and 1982.
Inflation: While inflation (both Personal Consumption Expenditure (PCE) and Headline) was much higher in the 1970s and 1980s, the Fed slammed on the brakes aggressively in the early 1980s in order to put up a serious fight against inflation. Across all hiking cycles since the 1970s, there were just a few instances where equity returns ended up negative (March 1974, Feb 1980, May 1981). All three episodes saw hiking cycle average year-over-year (y/y) Headline Consumer Price Index (CPI) numbers north of 10% and y/y PCE of 8 to 10%. These are not levels we are seeing today. The early 1980s were particularly painful as the aggressive tightening led to a recessionary environment where new orders PMI levels fell below 50 consistently. Fed hiking cycles since the 1990s have coincided with low and manageable inflation. More importantly, the Fed has shown humility in reversing course in the hiking cycles of 1994 and 1997, when they promptly reversed the hikes when inflation concerns turned out to be overdone. In fact, the March 1997 cycle was a unique one where the Fed responded with a 25bps hike due to a rapidly falling unemployment rate. It turned out that this was the only hike of the cycle, which ended in September 1998 due to the absence of inflation. Core inflation continued to trend lower as productivity growth offset wage pressure.
Implied Hike Pace Per Quarter / Average Length of Hiking Cycle: The implied hike pace per quarter has come down significantly as the Fed successfully contained the inflation genie in a bottle after fierce hikes in the 1980s.
The average length of a hiking cycle has also been much longer post 1990s, hence giving way to a more gradual hiking path. This is taken as a positive as risk assets are more able to digest rising rates over a longer runway with more clarity as the Fed significantly improved its communication with regards to forward guidance to market participants over time.
Exhibit 2: Macroeconomic environment during past hiking cycles
The Truth Is Not Always Ugly
While it is never a pleasant experience living through a volatile episode like the one we are in right now, sparked by hawkish pivots from central bankers, history has shown that steady hands prevail. If we can use history as a guide, the key lesson here is that risk assets have, on average, delivered positive returns through numerous Fed hiking cycles since the 1970s.
- International equities have been a winner in previous Fed hiking cycles, especially so in the initial phases (3 months and 12 months) after the first rate hike is delivered. Strong U.S. growth supports the global growth picture and, hence, traditionally more cyclical equity regions like Europe and Japan have outperformed.
- Commodities also perform strongly in the initial 3-month phase as it continues to be an asset class investors gravitate to as a diversifier against inflation. The dollar’s decline in previous cycles has also acted as a tailwind for emerging markets and commodities.
- Cyclicals have historically outperformed defensives, and the degree of outperformance is most pronounced 12 months after the first rate hike is delivered. In the macro conditions section earlier, we had shown how the Fed has historically successfully maneuvered the vast majority of rate hiking cycles without choking off growth. New orders PMI levels have on average stayed above 50 (expansionary territory) during all rate hiking cycles since the 1970s. The positive growth environment supports the performance of cyclically exposed sectors.
- Value has also outperformed growth, but the degree of outperformance has been more muted, even up to 12 months after the first rate hike is delivered. While value is typically associated with Financials and Energy, it is worth noting that going into a rate hiking cycle, the sectors that have cheapened and would be included in the value bucket can very well include defensive sectors like Health Care. Currently, MSCI USA Value’s biggest exposure is Financials (~20%). The next biggest exposure is actually Health Care (~18%), followed by Technology (~12%). Investors should consider sector-neutral value exposure for a purer representation of the factor, or active management to select value sectors that can outperform.
- U.S. credit is a mixed bag, with U.S. high yield (HY) spread returns managing to deliver small positive returns through the hiking cycle while U.S. investment grade (IG) spread returns are negative. HY spread returns have been traditionally highly correlated to U.S. equities, so it is no surprise that HY can still deliver in an environment where growth is strong. However, compared to U.S. equities, U.S. HY underperforms in the initial phases after the first rate hike is delivered as the asset class digests the impact from higher rates. On top of delivering negligible spread returns, investors should note that U.S. IG is also an asset class with long duration (average of 6.6 years since 1989). Hence, the interest rate duration risk should be top of mind when investing in this asset class.
Exhibit 3: Risk asset returns have been positive during previous hiking cycles
Average annualized local currency returns of risk assets during hiking cycles
In conclusion, it might feel like all doom and gloom as the Fed pivots away from an extremely accommodative stance. However, we should bear in mind that overall growth still remains relatively robust and financial conditions are still accommodative (U.S. real rates are still negative!).
We fully expect growth to stay supported with a prudent Fed hiking into strength, barring an inflation shock that would cause the Fed to hike aggressively like the inflation-fighting periods in the 1980s.
Looking at the contribution to U.S. headline CPI in Exhibit 4 gives us comfort as >5% of the 7.5% headline number is coming from non-Phillips Curve sensitive categories like goods and energy. This means the inflation that we are seeing at the moment is not sticky inflation and so far the bleed-through to services inflation (more sticky) has been relatively well contained, though risks could be biased to the upside as the U.S. housing market remains strong. We expect goods inflation led by reopening sensitive categories like New and Used Vehicles to moderate alongside energy prices as supply side constraints iron themselves out through the course of the year.
Exhibit 4: Expect U.S. inflation to moderate as goods inflation abates
Based on our evaluation of how different risk assets perform across historical hiking cycles, we think investors should:
- Diversify U.S. equity exposures by adding to international equities.
- Be selective in value vs. growth. Value exposures have typically outperformed growth during rate hiking cycles over the longer term. While value outperforms growth especially in the initial phase after the first rate hike is delivered, it deteriorates over the next 12-month time period. The weaker relative performance over the most recent hiking cycle (1990s+) also argues for more balance between both exposures on a longer-term basis or an active selection of sectors within those styles.
- Tactically allocate to cyclical industries like banks, which see their bottom lines benefit from higher rates. Cyclical exposures have outperformed defensives during rate hiking cycles and the performance differentials are most pronounced 12 months after the first rate hike is delivered.
- Consider Commodities to diversify against bad inflation outcomes. Commodities are also an asset class that has delivered positive returns during rate hiking cycles, with the positive momentum being strongest in the initial phase (3 months) after the first rate hike is delivered. As various economies around the world gradually return to normalcy this year, demand is expected to stay robust, and supply deficits and geopolitical tensions should keep commodity prices well anchored.
- Be aware of duration risk in U.S. IG credit. U.S. HY can continue to deliver spread returns as long as the growth remains strong and the default environment remains benign, which is similar to the credit conditions that we are seeing today. However, given starting valuations and the stage of the cycle, we still prefer equities to credit when expressing a pro-risk view for multi-asset portfolios.