The recent hawkish stance of the Federal Reserve, amidst a strong rally in the stock market, has presented investors with a dilemma: how to maintain exposure to rising equities while protecting themselves against potential disruptions that tighter monetary policy can bring.
Investors are closely monitoring the Federal Reserve’s future policy decisions and economic indicators to assess the potential impact on stock markets and adjust their investment strategies accordingly.
As expected, the central bank decided to keep rates unchanged on Wednesday. However, it surprised some market participants by signaling that borrowing costs are likely to increase by another half a percentage point by the end of the year.
This move is a response to the ongoing strength of the economy and a slower decline in inflation. Following this announcement, expectations for peak interest rates rose.
Many investors believe that an additional 50 basis points increase in rates, if deemed necessary by the Fed, is unlikely to halt the rally in U.S. stocks. The S&P 500 has already risen by 24% from its lows last year.
The central bank has already implemented a 500 basis points rate increase since last year and is widely believed to be nearing the end of its rate hike cycle.
However, concerns are growing that tighter monetary policy could increase the likelihood of disruptions in the financial system, similar to the crisis that led to several high-profile bank collapses earlier this year and sparked weeks of market volatility.
Although the U.S. economy has shown resilience overall, some investors are cautious about areas that may be particularly vulnerable as easy money becomes scarce.
Commercial real estate is one such area, where a wave of defaults could have implications for banks and the broader economy. Other credit market sectors are also considered potential weak spots.
Josh Emanuel, chief investment officer at Wilshire, warns that pushing further without allowing more time could lead to broken elements in the system. He expresses concerns about a growing risk of a credit crunch.
However, Emanuel also considers it dangerous to underweight equities, given their recent rally driven by diminishing recession fears and excitement surrounding developments in artificial intelligence. As a result, he avoids assets that could be significantly impacted if market stress suddenly increases, such as small-cap stocks.
The S&P 500 experienced a slight 0.1% increase on Wednesday, fluctuating between gains and losses. Bond yields, which move inversely to prices, edged higher. Year-to-date, the S&P 500 has risen by 15%, while the Nasdaq has gained 30%.
James St. Aubin, chief investment officer at Sierra Investment Management, has been increasing equity positions during the rally but plans to reverse this stance if the trend shifts.
He remains watchful for further strains in the banking system, which he believes can be exacerbated by prolonged low interest rates and an inverted yield curve, making lending less profitable for banks.
Echoing similar sentiments, DoubleLine Capital CEO Jeffrey Gundlach suggests that if the Fed follows its current path, there is a risk of breaking something in the economy.
He recommends increasing allocations to high-quality bonds while reducing stock holdings, noting that rising yields have made bonds cheaper and more attractive to income-seeking investors.
Mark Heppenstall, chief investment officer of Penn Mutual Asset Management, believes that an expanding stock market rally could loosen credit conditions, potentially worsening consumer prices. This outcome is undesirable for the Fed, which aims to fight inflation.
It is important to note that higher interest rates do not necessarily guarantee cracks in the economy, nor would such an event, if it were to occur, necessarily deal a catastrophic blow to stocks.
The S&P 500 has risen by 14% from its low point reached after the banking crisis in March.