Asset Allocation Update: Watch the Fed

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The biggest question in the markets today is whether the Fed will be willing to crush inflation, even if it means weaker stock markets. The interest rate markets do not think they have the will. They predict the Fed will raise rates to around 3.25% and then give up even with inflation well above the Fed’s 2% target. We believe the markets could be wrong and the Fed is going further – raising rates to at least pre-Global Financial Crisis (GFC) levels of 5.25% or even 8%.

Even if we are wrong on the terminal rate, but on the balance of risk for the Fed, that means there are even more downsides for risky markets like equities. Therefore, the late rally in equities in May, which allowed equities to generate a stable return for the month, is likely temporary (chart 2). Higher yields mean lower price-to-earnings ratios and weaker growth prospects. We remain underweight equities.

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The biggest question in the markets today is whether the Fed will be willing to crush inflation, even if it means weaker stock markets. The interest rate markets do not think they have the will. They predict the Fed will raise rates to around 3.25% and then give up even with inflation well above the Fed’s 2% target. We believe the markets could be wrong and the Fed is going further – raising rates to at least pre-Global Financial Crisis (GFC) levels of 5.25% or even 8%.

Even if we are wrong on the terminal rate, but on the balance of risk for the Fed, that means there are even more downsides for risky markets like equities. Therefore, the late rally in equities in May, which allowed equities to generate a stable return for the month, is likely temporary (chart 2). Higher yields mean lower price-to-earnings ratios and weaker growth prospects. We remain underweight equities.

Crypto markets will also be impacted by this backdrop, and we are uncovering specific vulnerabilities, especially with the Luna/TerraUSD debacle. As a result, the last month (May) saw terrible performance in crypto with Bitcoin down 18% and Ethereum down 31% (Chart 2). Crypto’s YTD Sharpe ratios have now fallen to similar levels to stocks. We’ve been writing a lot around this outcome and further weakness in stablecoins and so moved into a neutral stance during the month (from an overweight position). We remain neutral.

As with the rest of the markets, we remain short on bonds, especially given our view of the Fed, and remain overweight on commodities given the poor supply dynamics. And of course, we love being overweight. As we wrote in our previous asset allocation update, when markets are fragile, capital preservation is paramount and liquidity is king.

Finally, in terms of equity sectors, here are our favorite views:

  • In the United States we like to be Overweight financials, homebuilders, large-cap value, reopening trades, semiconductors, traditional infrastructure and underweight large cap growth, communications, consumer discretionary, materials and technology.
  • In Europe we like to be Overweight finance and renewable energy.

Good luck!

Bilal Hafeez is the CEO and Editor-in-Chief of Macro Hive. He spent over twenty years doing research at major banks – JPMorgan, Deutsche Bank and Nomura, where he held various “global head” positions and researched currencies, rates and cross-markets.

(The commentary in the above article does not constitute an offer or solicitation, or a recommendation to implement or liquidate any investment or to engage in any other transaction. It should not be relied upon as the basis for any decision investment or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)

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