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Mid-Cycle: Keep Calm and Carry On

By Ben Viemeister, CFA

What might monetary tightening bring for markets?

Markets have navigated the recovery phase of the economic cycle supported by monetary and fiscal authorities who have injected record levels of liquidity into the financial system. That’s changing. The Federal Reserve is expected to increase interest rates in 2022, to help fight inflation, while U.S. fiscal policy momentum has stalled. Naturally, this has driven some sensationalist stories about how the tightening liquidity trajectory portends peril. We disagree. Let’s walk through what could await each asset class during this next economic phase.

Domestic Equities

Federal Reserve Chairman Jerome Powell is embarking on the 21st interest rate tightening cycle since 1950. Over the previous 20 cases, U.S. equities have risen 14 times during the following year after the first hike. The average increase was 15%. For the six cases where U.S. equities fell, the average decline was 7%. Across all 20 cases, the average return was 9%, modestly below the long-term average return for U.S. equities. Over the three most recent cases (1999, 2004, 2015), U.S. equities returned 8%, with an average 9% intra-year drawdown.  This could result in relatively disappointing returns after such a strong 2021 in which the S&P 500 returned 29% with a 5% intra-year drawdown. History suggests investors should normalize their return expectations going forward as liquidity conditions tighten, and not simply extrapolate recent results. 

History also reminds investors they will need some patience. Over the past three tightening cycles, U.S. equities were down low-to-mid single digits, one-to-three months following the first hike.

A final key lesson from the past tightening cycles is leadership can change. Growth equities, especially those that trade at elevated valuations where cash flows are in the distant future, often can face headwinds from higher interest rates. Value has outpaced growth during the first twelve months after the first rate hike the past couple cycles. Potentially helping that repeat this cycle are today’s starting valuations. On average, the last two cycles started with growth trading at a 31% premium to value. Now that premium is 100%, the highest since 2000. Meanwhile small cap companies have shown relatively strong performance during tightening cycles. And this was with less favorable valuation starting conditions than today. At the start of the last two rate tightening cycles, small caps traded at a 42% average premium to large caps, while they trade at only an 11% premium now, the lowest level since 2002. A shift to more value and small cap leadership would represent a change from 2021.

Foreign Equities

Outside the U.S., over the past three tightening cycles, Foreign Equities have averaged a 12% return in the year after the first hike. Emerging markets exceeded that number. These indices have notable exposures to sectors that can benefit from rising rates (like financials) and resource demand (like materials).  A few factors potentially setup Foreign Equities to have another period of solid returns during a Fed tightening cycle: 1) Recovery in many foreign economies that have lagged the U.S. due to COVID-induced economic hiccups; 2) Stimulus and more constructive policy outlook vs 2021 in the largest foreign market, China; 3) Valuations as the asset class currently trades at a 33% discount to U.S. Equities vs a 14% average discount at the start of the last two rate tightening cycles, while its dividend yield of 3% is more than double the U.S. dividend yield, a record yield premium vs the U.S. 

Fixed Income

Meanwhile, the yield setup for Fixed Income presents a headwind to returns. Over the past three tightening cycles, the average one-year return for Fixed Income after the first interest rate hike was 4%. A key difference this cycle vs the past few cycles is the starting yield. The yield on the U.S. 10-year Treasury averaged 4.2% when the Federal Reserve first raised rates over those three cycles. Today the 10-year Treasury yield is 1.6%. A lower starting yield raises the probability that over this upcoming tightening cycle, Fixed Income returns could fall short of that historical 4% average, as the starting yield is not as significant a buffer to offset the negative change in bond value from rising rates. This supports the need for: 1) targeting the spots on the yield curve that offer the most attractive trade-off between income and duration risk; 2) investing in alternative sources of income within Fixed Income via sub-classes like bank loans, and across asset classes, like pipelines in Natural Resources, REITs in Real Estate, niche assets like merger arbitrage in Alternatives, and dividend-payers across Global Equities.

Natural Resources

The main reason for the Fed tightening monetary policy is inflation. A key asset class to protect against continued inflation is Natural Resources. Over the past three cycles, the asset class has generated returns that were above its long-term average in the year following the first rate hike. Sustained solid economic demand, combined with a lag in bringing on new supply can help Natural Resource returns. Supply conditions at the start of a rate tightening cycle are important. Many commodities start this cycle with below normal inventories after restrained investment in new supply.

Real Estate

Another asset class that can protect against inflation, while also picking up some of the income slack created by low-yielding fixed income, is Real Estate. Real Estate has more of a mixed record than Natural Resources when it comes to returns over the year following the first rate hike. Over the three most recent cycles, Real Estate produced a positive return each year following the first hike. But the 14% average return was skewed higher by 2004, when valuations were more attractive than today, with U.S. REIT forward Price-to-FFO (funds from operations) at 15x vs 24x today. Despite this, opportunities to add value in this asset class still exist as international real estate trades at a 37% discount to the U.S., and multiple sub-segments of U.S. real estate trade at reasonable valuations with attractive profit growth outlooks.

Tightening Trajectory

Opportunities clearly exist across asset classes as monetary tightening occurs, but when will the tightening start? A few months ago, the Fed set expectations for the first rate hike to occur at the end of 2022. Inflation had other plans. Core personal consumption expenditure inflation hit 4.7% in November 2021, the highest since 1983. The Fed quickly changed its tune, accelerating expectations for the first rate hike to as early as March. Likewise, the expectations for when the Fed would conclude its tapering process were also pulled forward to March.  Against this swifter monetary tightening timeline, the fiscal policy outlook also became less supportive, as the original Build Back Better Act was recently rejected and negotiations are ongoing for a smaller compromise.

Inflation (and to a lesser extent, employment) will continue to dictate the pace of tightening. The general market consensus is the Fed will raise interest rates three times in 2022, leaving it at around 0.9% and on pace to hit the Fed’s longer run target of 2.5%. If supply chains heal and goods demand normalizes, inflation may start to trend toward more normal levels in the second half of 2022, allowing the Fed to follow a slower tightening pace.

Regardless of the tightening trajectory, Osborne Partners’ dynamic multi-asset investment strategy is positioned to navigate the market’s transition from early to mid-economic cycle.

Ben Viemeister, CFA

Ben is an Investment Analyst at OPCM and has over 10 years of experience. Ben is a member of the OPCM Investment Management Team, and is responsible for research coverage in all asset classes. Ben is a member of CFA Society San Francisco and CFA Institute. Ben graduated summa cum laude from Lynchburg College with a B.A. in Economics and is a CFA Charterholder.
The opinions expressed herein are strictly those of Osborne Partners Capital Management, LLC ("OPCM") as of the date of the material and is subject to change. None of the data presented herein constitutes a recommendation or solicitation to invest in any particular investment strategy and should not be relied upon in making an investment decision. There is no guarantee that the investment strategies presented herein will work under all market conditions and investors should evaluate their ability to invest for the long-term. Each investor should select asset classes for investment based on his/her own goals, time horizon and risk tolerance. The information contained in this report is for informational purposes only and should not be deemed investment advice. Although information has been obtained from and is based upon sources OPCM believes to be reliable, we do not guarantee its accuracy and the information may be incomplete or condensed. Past performance is not indicative of future results. Inherent in any investment is the possibility of loss.