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Fed Sets Course for Milder Interest-Rate Rise in February

Officials could begin weighing whether and when to pause rate increases this spring

By NICK TIMIRAOS
Mon, Jan 23, 2023 8:45amGrey Clock 4 min

U.S. Federal Reserve officials are preparing to slow interest-rate increases for the second straight meeting and debate how much higher to raise them after gaining more confidence inflation will ease further this year.

They could begin deliberating at the Jan. 31-Feb. 1 gathering how much more softening in labour demand, spending and inflation they would need to see before pausing rate rises this spring.

In recent public statements and interviews, Fed officials have said slowing the pace of rate increases to a more traditional quarter percentage point would give them more time to assess the impact of their increases so far as they determine where to stop.

Officials called attention to how it takes time for the full effect of higher rates to cool economic activity when they stepped down to a half-point rate rise in December, following four consecutive increases of 0.75 point.

“And that logic is very applicable today,” said Fed Vice Chair Lael Brainard in remarks last week. Raising rates in smaller increments “gives us the ability to absorb more data…and probably better land at a sufficiently restrictive level.”

To combat high inflation last year, the Fed reeled off the most rapid series of rate rises since the early 1980s, raising its benchmark federal-funds rate by 4.25 percentage points. A quarter-point increase next month would bring the rate to a range between 4.5% and 4.75%.

Most Fed officials projected in December the rate would rise to a peak between 5% and 5.25%. That would imply two more quarter-point increases after the likely bump next month. Investors in interest-rate futures markets expect the Fed to make two more quarter-point increases—at the coming meeting and again at the Fed’s subsequent meeting in mid-March, according to CME Group.

The Fed raised rates seven times last year. The likely decision to approve a smaller increase in February reflects officials’ growing confidence that the economy is responding to their efforts to curb demand and bring down inflation.

In recent weeks, government data and business surveys have pointed to a steeper drop-off in manufacturing activity and new orders for service-sector firms as well as a pullback in consumer spending on goods.

The central bank’s rate increases are aimed at slowing inflation by reducing demand, “and there is ample evidence that this is exactly what is going on in the business sector,” Fed governor Christopher Waller, an early and vocal advocate for aggressive rate rises last year, said on Friday. Mr. Waller said he would favour a quarter-point rate rise at the coming meeting.

The Commerce Department is set to release this week the December figures for the Fed’s preferred inflation gauge, the personal-consumption expenditures price index. Excluding food and energy prices, the so-called core PCE index likely rose 4.5% from a year earlier and at a 3.1% three-month annualised rate in December, Ms. Brainard said.

Officials could use their post meeting statement on Feb. 1 to indicate they expect to continue raising rates as they probe where to pause. But they are unlikely to provide precise guidance because coming decisions will depend heavily on new data about the economy.

Some have also suggested that even if they hold rates steady this summer, they will indicate they remain more likely to lift rates than to cut them. After the Fed pauses, “we’ll need to remain flexible and raise rates further if changes in the economic outlook or financial conditions call for it,” said Dallas Fed President Lorie Logan in a recent speech.

At the coming meeting, officials could deliberate two important questions: How long does it take for the full effects of the Fed’s rate rises to influence hiring and overall economic demand? And how much could inflation slow due to other factors such as easing supply-chain bottlenecks or lower costs of fuel and other commodities?

Some could call for delaying any pause if the economy doesn’t weaken much in the months ahead. They think the time between when the Fed raises rates and when they slow the economy is relatively short and the economy will soon feel the worst of any policy-induced slowdown.

Others could argue for a somewhat earlier pause, believing the effects take longer to play out or could be more potent.

Divisions have surfaced. St. Louis Fed President James Bullard said recently he would prefer a larger half-point rate increase at the coming meeting because he doesn’t think rates are high enough to thoroughly beat inflation. “You’d probably have to get over 5% to say with a straight face that we’ve got the right level,” he said in an interview. “Why not go to where we’re supposed to go?…Why stall and not quite get to that level?”

Several of his colleagues have argued for greater flexibility to see if the easing of pandemic- and war-related disruptions brings inflation down more rapidly. As evidence builds that higher rates are working as intended, “why would we try to…really put the clamps down on the economy and really risk losing the good things we have going, like the labor market?” Philadelphia Fed President Patrick Harker said last week. “I just don’t see doing that.”

Fed officials have long expected inflation to fall as supply-chain bottlenecks and commodity-market disruptions eased, but inflation instead rose through the first half of 2022 before moving sideways, according to the Commerce Department’s gauge.

Inflation has declined over the past three months due largely to falling fuel prices and prices of goods, such as used cars. There are signs soaring rents and other housing costs are set to cool notably amid a sharp slowdown in demand, though that isn’t expected to show up in official inflation measures until later this year.

As a result, Fed Chair Jerome Powell and several colleagues have shifted their focus recently toward a narrower subset of labor-intensive services by excluding prices for food, energy, shelter and goods. Inflation in that category has been around 4.4% on both a 12- and three-month basis, up from around 2.3% on average between 2010 and 2019.

Officials believe that category could reveal whether higher wage costs are passing through to consumer prices.

If services inflation is high because paychecks are rising in lockstep with prices, as occurred during the 1970s, then Fed officials would want to see hiring slow more.

But if price increases for services such as restaurant meals, car insurance and airfares instead reflect the ripple, or “pass-through,” effects of some of the global dislocations that are now reversing, services inflation might moderate faster and without as significant a weakening of labor markets.

The recent inflation slowdown, together with the lagging impact of the Fed’s rate rises that could continue to slow the economy, “may provide some reassurance that we are not currently experiencing a 1970s-style wage-price spiral,” said Ms. Brainard.

Fed officials last month revised higher their projections for inflation this year in part due to fears that wage growth was running too high. Signs since then that wage growth is slowing could weigh prominently in the debate over how soon to pause.

Officials will have two more months of several widely watched economic indicators, including on hiring and inflation, before their March 21-22 meeting. They pay close attention to a detailed measure of worker compensation called the employment-cost index, which is set for release on Jan. 31.

The report could offer further confirmation that wage growth slowed at the end of last year.

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Where Are Stocks, Bonds and Crypto Headed Next? Five Investors Look Into Crystal Ball

Equities are often seen as expensive after promising start to 2023

By CAITLIN MCCABE
Mon, Jan 30, 2023 7 min

A new trading year kicked off just weeks ago. Already it bears little resemblance to the carnage of 2022.

After languishing throughout last year, growth stocks have zoomed higher. Tesla Inc. and Nvidia Corp., for example, have jumped more than 30%. The outlook for bonds is brightening after a historic rout. Even bitcoin has rallied, despite ongoing effects from the collapse of the crypto exchange FTX.

The rebound has been driven by renewed optimism about the global economic outlook. Investors have embraced signs that inflation has peaked in the U.S. and abroad. Many are hoping that next week the Federal Reserve will slow its pace of interest-rate increases yet again. China’s lifting of Covid-19 restrictions pleasantly surprised many traders who have welcomed the move as a sign that more growth is ahead.

Still, risks loom large. Many investors aren’t convinced that the rebound is sustainable. Some are worried about stretched stock valuations, or whether corporate earnings will face more pain down the road. Others are fretting that markets aren’t fully pricing in the possibility of a recession, or what might happen if the Fed continues to fight inflation longer than currently anticipated.

We asked five investors to share how they are positioning for that uncertainty and where they think markets could be headed next. Here is what they said:

‘Animal spirits’ could return

Cliff Asness, founder of AQR Capital Management, acknowledges that he wasn’t expecting the run in speculative stocks and digital currencies that has swept markets to kick off 2023.

Bitcoin prices have jumped around 40%. Some of the stocks that are the most heavily bet against on Wall Street are sitting on double-digit gains. Carvana Co. has soared nearly 64%, while MicroStrategy Inc. has surged more than 80%. Cathie Wood‘s ARK Innovation ETF has gained about 29%.

If the past few years have taught Mr. Asness anything, it is to be prepared for such run-ups to last much longer than expected. His lesson from the euphoria regarding risky trades in 2020 and 2021? Don’t count out the chance that the frenzy will return again, he said.

“It could be that there are still these crazy animal spirits out there,” Mr. Asness said.

Still, he said that hasn’t changed his conviction that cheaper stocks in the market, known as value stocks, are bound to keep soaring past their peers. There might be short spurts of outperformance for more-expensive slices of the market, as seen in January. But over the long term, he is sticking to his bet that value stocks will beat growth stocks. He is expecting a volatile, but profitable, stretch for the trade.

“I love the value trade,” Mr. Asness said. “We sing about it to our clients.”

—Gunjan Banerji

Keeping dollar’s moves in focus

For Richard Benson, co-chief investment officer of Millennium Global Investments Ltd., no single trade was more important last year than the blistering rise of the U.S. dollar.

Once a relatively placid area of markets following the 2008 financial crisis, currencies have found renewed focus from Wall Street and Main Street. Last year the dollar’s unrelenting rise dented multinational companies’ profits, exacerbated inflation for countries that import American goods and repeatedly surprised some traders who believed the greenback couldn’t keep rallying so fast.

The factors that spurred the dollar’s rise are now contributing to its fall. Ebbing inflation and expectations of slower interest-rate increases from the Fed have sent the dollar down 1.7% this year, as measured by the WSJ Dollar Index.

Mr. Benson is betting more pain for the dollar is ahead and sees the greenback weakening between 3% and 5% over the next three to six months.

“When the biggest central bank in the world is on the move, look at everything through their lens and don’t get distracted,” said Mr. Benson of the London-based currency fund manager, regarding the Fed.

This year Mr. Benson expects the dollar’s fall to ripple similarly far and wide across global economies and markets.

“I don’t see many people complaining about a weaker dollar” over the next few months, he said. “If the dollar is falling, that economic setup should also mean that tech stocks should do quite well.”

Mr. Benson said he expects the dollar’s fall to brighten the outlook for some emerging- market assets, and he is betting on China’s offshore yuan as the country’s economy reopens. He sees the euro strengthening versus the dollar if the eurozone’s economy continues to fare better than expected.

—Caitlin McCabe

Stocks still appear overvalued

Even after the S&P 500 fell 15% from its record high reached in January 2022, U.S. stocks still look expensive, said Rupal Bhansali, chief investment officer of Ariel Investments, who oversees $6.7 billion in assets.

Of course, the market doesn’t appear as frothy as it did for much of 2020 and 2021, but she said she expects a steeper correction in prices ahead.

The broad stock-market gauge recently traded at 17.9 times its projected earnings over the next 12 months, according to FactSet. That is below the high of around 24 hit in late 2020, but above the historical average over the past 20 years of 15.7, FactSet data show.

“The old habit was buy the dip,” Ms. Bhansali said. “The new habit should be sell the rip.”

One reason Ms. Bhansali said the selloff might not be over yet? The market is still underestimating the Fed.

Investors repeatedly mispriced how fast the Fed would move in 2022, wrongly expecting the central bank to ease up on its rate increases. They were caught off guard by Fed Chair Jerome Powell‘s aggressive messages on interest rates. It stoked steep selloffs in the stock market, leading to the most turbulent year since the 2008 financial crisis. Now investors are making the same mistake again, Ms. Bhansali said.

Current stock valuations don’t reflect the big shift coming in central-bank policy, which she thinks will have to be more aggressive than many expect. Though broader measures of inflation have been falling, some slices, such as services inflation, have proved stickier. Ms. Bhansali is positioning for such areas as healthcare, which she thinks would be more insulated from a recession than the rest of the market, to outperform.

“The Fed is determined to win the war since they lost the battle,” Ms. Bhansali said.

—Gunjan Banerji

A better year for bonds seen

Gone are the days when tumbling bond yields left investors with few alternatives to stocks. Finally, bonds are back, according to Niall O’Sullivan of Neuberger Berman, an investment manager overseeing about $427 billion in client assets at the end of 2022.

After a turbulent year for the fixed-income market in 2022, bonds have kicked off the new year on a more promising note. The Bloomberg U.S. Aggregate Bond Index—composed largely of U.S. Treasurys, highly rated corporate bonds and mortgage-backed securities—climbed 3% so far this year on a total return basis through Thursday’s close. That is the index’s best start to a year since it began in 1989, according to Dow Jones Market Data.

Mr. O’Sullivan, the chief investment officer of multi asset strategies for Europe, the Middle East and Africa at Neuberger Berman, said the single biggest conversation he is currently having with clients is how to increase fixed-income exposure.

“Strategically, the facts have changed. When you look at fixed income as an asset class…they’re now all providing yield, and possibly even more importantly, actual cash coupons of a meaningful size,” he said. “That is a very different world to the one we’ve been in for quite a long time.”

Mr. O’Sullivan said it is important to reconsider how much of an advantage stocks now hold over bonds, given what he believes are looming risks for the stock market. He predicts that inflation will be harder to wrangle than investors currently anticipate and that the Fed will hold its peak interest rate steady for longer than is currently expected. Even more worrying, he said, it will be harder for companies to continue passing on price increases to consumers, which means earnings could see bigger hits in the future.

“That is why we are wary on the equity side,” he said.

Among the products that Mr. O’Sullivan said he favours in the fixed-income space are higher-quality and shorter-term bonds. Still, he added, it is important for investors to find portfolio diversity outside bonds this year. For that, he said he views commodities as attractive, specifically metals such as copper, which could continue to benefit from China’s reopening.

—Caitlin McCabe

 

Find the fear, and find the value

Ramona Persaud, a portfolio manager at Fidelity Investments, said she can still identify bargains in a pricey market by looking in less-sanguine places. Find the fear, and find the value, she said.

“When fear really rises, you can buy some very well-run businesses,” she said.

Take Taiwan’s semiconductor companies. Concern over global trade and tensions with China have weighed on the shares of chip makers based on the island. But those fears have led many investors to overlook the competitive advantages those companies hold over rivals, she said.

“That is a good setup,” said Ms. Persaud, who considers herself a conservative value investor and manages more than $20 billion across several U.S. and Canadian funds.

The S&P 500 is trading above fair value, she said, which means “there just isn’t widespread opportunity,” and investors might be underestimating some of the risks that lie in waiting.

“That tells me the market is optimistic,” said Ms. Persaud. “That would be OK if the risks were not exogenous.”

Those challenges, whether rising interest rates and Fed policy or Russia’s war in Ukraine and concern over energy-security concerns in Europe, are complicated, and in many cases, interrelated.

It isn’t all bad news, she said. China ended its zero-Covid restrictions. A milder winter in Europe has blunted the effects of the war in Ukraine on energy prices and helped the continent sidestep recession, and inflation is slowing.

“These are reasons the market is so happy,” she said.

—Justin Baer

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