A Fed too far? Positioning portfolios for what's ahead

Digesting the Fed’s news, stocks revisited their lowest levels of the year last week, mortgage rates rose to new highs, home sales fell for the 7th consecutive month and the US dollar soared to new 20-year highs.

The Fed is undertaking a near-term “pain maximizing” strategy. We see the probability of a US recession next year at 70% and we expect a material fall in employment. The pain inflicted on households and small businesses will have lingering negative impacts into 2024.

We strongly doubt that the Fed’s higher rate views, together with Quantitative Tightening (“QT”), are compatible with its expectation for positive growth in 2023.

History shows the Fed’s policy forecast can change abruptly and is secondary to the Fed achieving its economic goals. We can envision that the Fed will reverse policy later in 2023 after several months of major employment declines.

Given this outlook, investors should prioritize capital preservation and look to high quality fixed income in portfolios. Short-duration US investment grade fixed income opportunities now yield between 5% and 7% across various market segments. Among the assets we believe investors should consider are US Treasuries, investment grade bonds, municipal bonds and notes, and preferred securities.

Specifically on the equity side, our macro-outlook suggests that the next 6 months of equity returns remain highly uncertain, though we do not expect a severe collapse in markets akin to the 2007-08 period. For the time being, we believe there can be better risk/reward in strategies that can shield principal loss while generating income. 

With the market pricing an elevated cost for buying protection out over the next year or two, this creates potential opportunities for suitable investors to earn a fixed coupon or use those funds to strategically accumulate positions in equities if dips occur. Of course, there are downside risks including loss of principal or changes to issuer credit quality, which should be understood before considering any strategy.