The markets are currently pricing in a good chance that the first policy rate increase from the Federal Reserve (Fed) will come in March 2022. So how should one position stock portfolios going into a tightening cycle?
As discussed in more detail previously, stocks historically do not seem bothered before a tightening cycle from the Fed. Other things besides monetary policy impact stocks, but stocks are not destined to be poor performers leading up to a rate hike. Stocks appear to get more jittery after the first hike, perhaps with good reason since the last three hiking cycles have ended in recession.
The analysis of what has historically worked during rate hike cycles is complicated by a lack of a large number of cycles and less data available for parsing the performance of the more “ancient” history. For this reason, this analysis will combine a study of history along with some thoughts regarding the present environment.
During these cycles, higher dividend stocks and dividend growers have generally had a good track record. This performance makes some logical sense since dividend-payers, particularly dividend growers, tend to be stable companies. In addition, dividend stocks are considered a version of value investing. Value has a long history of solid performance but has underperformed for quite a long period recently. Valuations should be a tailwind to value stocks as they sell at the lowest valuation relative to growth stocks since the technology bubble. In addition, rising yields should benefit value stocks, all other things being equal. The risks are that value stocks tend to be more exposed to economic downturns, and growth stocks have exhibited better resilience during Covid-related business disruptions.
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The other area worth of focus is quality stocks. Quality stocks tend to be defined as having a high return on equity (ROE) and less debt. Quality has managed to perform well during past hiking cycles on average. In addition, quality has been shown to earn high risk-adjusted returns both in the U.S and globally. Investing in quality also puts you in good company as there is evidence that Warren Buffett used quality stocks as part of his investment formula for superior returns. The risk for quality is that an aggressive risk appetite continues to pervade, and quality should underperform in that situation. If the Fed hikes cause some concern about a policy error leading to a recession, quality should benefit.
Omicron and any other future variants add another level of uncertainty around economic activity and any future Fed policy actions. Assuming that Omicron remains highly contagious but does not lead to as many hospitalizations as previous strains of the virus, the Fed should be on track to hike in March. Consumer mobility still does not seem to be significantly negatively impacted by the increased infections, but this will need to be monitored. A strong December jobs report on Friday would provide another hint that markets should continue to expect a Fed liftoff in March.