Exposure rates of the Dorval Asset Management Range – 28th January 2022
Jerome Powell’s speech upped the game against inflation, while also acknowledging that the Fed only holds part of the solution. With US monetary policy that is both less accommodative and more guided by macroeconomic data, investors are concerned about financial conditions tightening too abruptly.
While the chair of the Federal Reserve clearly highlighted the strong US labor market and the end to the monetary “whatever it takes” approach, the debate still rages on questions over gradualism. The FOMC will publish its next projections at the March 16th meeting – there will be no meeting in February – and will unveil more details on the trajectory favored by its members. However, Powell has already suggested that the very gradual increase over 2015-2018 is not a good guide given that unemployment and inflation rates were in a very different situation at the start of this period. The fixed income markets reacted instantly and priced in five 25bp rate hikes out to the end of the year, which would bring the fed funds rate to 1.25% (cf. chart 1).
Five 25bp rate hikes expected for 2022
Trajectory for US short-term rates / Expected trajectory 6 months ago
We have seen localized valuation bubbles burst (green tech, unprofitable US tech, biotech, etc.) over the past several months, and until the start of 2022, this had happened against a backdrop of relative indifference. However, question marks now hang over the prospect of this spreading to all growth stocks and to the financial market as a whole. Opinions collide on this matter.
On the one hand, some will stress that valuations have been decreasing in an orderly manner, with no widespread financial tension for now (cf. chart 2). Credit spreads are widening, particularly on corporate bonds of lower quality, but they are a far cry from crisis levels. The emerging markets – deemed to be most sensitive to US monetary policy tightening – are not particularly affected, despite the US dollar’s sharp surge against the euro, yen and Australian dollar.
Valuations dwindling without major financial tension
St Louis Fed financial stress index
On the other hand, some observers attribute this lack of tension to investor complacency and are waiting for more tangible signs of “surrender” before taking risk again.
For now, our assessment is broadly of dwindling valuations and decrease in excessive positioning on certain major market capitalization size segments, fueling anxiety without any major impact on the real economy at this point. However, the risk scenario of an excessively sharp shock from the Fed is increasing, while it is not the majority expectation. In light of increased volatility, we maintain moderate exposure to risk in our asset allocation.