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Playing the Powell Put

Much of the bullish buoyancy of last year faded in the darkest December for markets since the depths of the Great Depression. The key catalyst? Worries that economic expansion was coming to an end. 


The Fed may just have pushed back the next recession

Jay Powell’s January “put” signalled a rate hike hiatus and formalised a frankly remarkable six-week volte face on the Fed’s policy path. Having previously spoken of operating almost on “autopilot”, the bank lowered its forward guidance and stands ready to lessen the pace of its balance sheet reductions.

The Fed seems willing to sustain the ongoing recovery rather than try to cool a possible overheating. An inflation flare-up is a distinct possibility. The trade-off? Greater support today for greater volatility tomorrow. Once again, good news is good news and so is bad news. Powell’s doves should keep equities flying high for now.


Goldilocks is back 

So where are we seeing opportunities? Our first instinct is to look for the more oversold parts of the market both in the US (small-caps and energy stocks) and internationally (Chinese and German equities). There is a caveat: despite the euphoria of more easy money, small-cap gains could still be gated by any renewal of the gridlock on Capitol Hill.

  • Lyxor Russell 2000 UCITS ETF

Broad, larger-cap indices like the S&P 500 may also enjoy the conditions, especially in the first half of the year. Any US-China trade deal could clinch the argument and catalyse a roaring Spring comeback. Value strategies – long the whipping boys – may come into focus over the medium term, especially as they tend to perform well post “peak” monetary tightening. 

The opposite is true for growth stocks. If, as now seems likely, we are past the tightening peak, we expect to see them show some performance weakness. Tech is the dominant growth sector and some highly leveraged tech titans face some additional challenges of their own in the form of much greater regulatory scrutiny and the possibility of government intervention.

At such a late stage of the economic cycle, demand for cyclical sectors is likely to wane. The focus should progressively turn to more defensive sectors such as Healthcare, Utilities and Communication Services. As the economy matures, energy stocks should gain more support from inflationary pressures and solid demand. 

The Fed’s dovishness, the trade truce and the cessation of the latest shutdown may have eclipsed worries over a sharp deceleration in US corporate profits, but the end of the cycle is still in sight. The first signs of a loss of momentum were felt earlier this year, with a sharp decline in the ISM manufacturing survey in January and dismal retail sales. The 35-day shutdown could have cost 0.1% of annualised growth per week. The effects of the fiscal push are fading. Greater downside pressure is inevitable towards the end of the year. Risk reducers may yet provide some more comfort – as they did prior to the Fed’s handbrake turn.

When pessimism trumps reality 

In fixed income, the markets have become excessively pessimistic about the outlook and have now almost ruled out a hike in 2019. We’re not buying that just yet - US payrolls and inflation figures continue to suggest growth is strong and underlying inflation pressures are building. The case for a mid-year hike still stands for now in our eyes at least. Regardless, a patient Fed helps the energy sector, weakens the dollar and should keep rates broadly stable. This is supportive of TIPS and breakevens, and we expect inflation-linked assets to outperform nominal bonds, at least over the first half of the year.

Among treasuries, we still favour short-dated assets because their yields are similar to their longer-dated counterparts and they come with much less interest rate risk.  Meanwhile, January’s credit rally may peter out. If the Fed does hike, it would tighten financial conditions and weigh on growth in the second half.  Either way, the fundamentals for credit look far better in Europe – even with the political risk – than they do in the US.

Inflation is likely to peak later this year but prior to that trade tariffs, high capacity utilisation rates, and higher labour cost pressures in developed markets will add some impetus, as will some form of recovery in oil prices. There’s more upside than downside risk at the current stage of the cycle, especially with the Fed seemingly content with its trade-off. 

Longer-term, inflation expectations are vulnerable to a worsening of financial conditions, especially in an environment of slowing growth. As late cycle assets, commodities can act as a hedge against higher inflation and downside pressures on the dollar. High-yield bonds also offer an attractive yield pickup should oil prices consolidate. The economic weakness we expect to see in 2020 casts a cloud over their medium-term horizon however.

All views & opinions: Lyxor ETF Equity and Fixed Income strategy teams, as at 20 February 2019 unless otherwise stated. These teams are part of Lyxor International Asset Management.

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