Quick takes on capital markets

17 Jun 2022

Federal Reserve: Bringing the pain

For the first time since 1994, the Federal Reserve has raised policy rates by 75 basis points, a testament to extraordinary inflation challenges that are showing little sign of letting up. As recession fears loom, investors should consider focusing their exposures on quality and stability, while an increased allocation to real assets could provide opportunity in an otherwise bleak market environment.

A 0.5% increase in the unemployment rate has always resulted in recession
12-month change in the 3-month rolling average of the U.S. unemployment rate, recessions are shaded, 1970 – present

Chart showing correlation between 0.5% increase in unemployment and there being a recession
Source: Bureau of Labor Statistics, National Bureau of Economic Research, Principal Global Investors. Data as of May 31, 2022.

Inflation concerns have reached a crescendo. Headline CPI inflation rose to a 40-year high in May, defying widespread assumptions that price pressures had peaked, while inflation expectations have also extended their upward climb. With these developments ringing loudly in its ears, the Federal Reserve (Fed) announced the first 0.75% policy rate increase since 1994.

The Fed dot plot sees an additional 175bps of hikes, taking the Fed funds rate to 3.8%, over the next 18 months which will likely push the unemployment rate up from 3.6% to 4.1%. An important feature of U.S. economic history is that there has never been a 0.5% increase in the unemployment rate without it resulting in recession.1

Many analysts don’t believe Fed forecasts go far enough. Indeed, we see policy rates rising to 4.25% by mid- 2023. This additional tightening could see unemployment rising above the Fed’s forecast, further raising the odds of recession.

Global central banks have clearly asserted that price stability sits above economic growth in their priority list, triggering major market upheaval. Against this painful backdrop, it becomes particularly important for investors to shift their equity and fixed income exposures towards quality and stability, while increasing their allocation to real assets, such as infrastructure and commodities, which still have some runway for potential outperformance.

1The Sahm Rule (created by former Fed economist Claudia Sahm) stipulates that recession occurs when the three-month moving average of the unemployment rate rises by at least 0.5% relative to its low during the previous 12-month period.

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