The Federal Reserve has held the fed funds rate at the 5.25%-5.5% level since last July. What impact are you starting to see this having on consumers and businesses?
For consumers and businesses, the biggest story continues to be inflation. The Fed’s rate hiking campaign to combat inflation hasn’t had the effect that the market or Fed were looking for, and now the situation is starting to erode consumer confidence. Maybe not as much if you were able to get a mortgage before 2022 versus after. But we're also beginning to see delinquencies rise. As we've gone through two years of inflation at a very high level, monthly bills are ticking up, consumers are faced with higher credit card interest rates, and it’s all starting to have an impact. The market has been looking for cuts; the Fed would like to cut interest rates, but until we can get past inflation, higher rates will continue to challenge consumers and, to a certain extent, businesses.
Given the Fed wants to cut interest rates this year, how are you currently positioned in your fixed income allocation?
In their last projection, the Fed expected to cut three times this year; at this point, the market is expecting less. For investors stationed in cash or at the short end of the yield curve where rates are highest, it’s important to remember that once the Fed starts cutting, those short-term rates will start to evaporate. So, we think it is important to be positioned a bit out of the curve. We believe the intermediate, three to seven-year part of the curve will most likely see the greatest benefit from rate cuts. There is still a bit of risk beyond the seven to ten-year area that you want to be aware of and account for if you are allocated to those longer bonds.
You have said equity valuations are “uncomfortably rich,” yet the market keeps moving higher. Where are you finding value in the equity market?
Certainly, some of the expensive areas of the market have become much more expensive as we’ve progressed through the year. But when talking about uncomfortable valuations, we’re referring to the overall top-down index level. There will always be unique opportunities for active managers to find attractively valued securities within large cap stocks, mid caps, and so on. Some sectors we see as having the best value here in the U.S. remain Energy and other dividend-paying sectors. Within Energy, you have companies with very attractive free cash flow generation with modest valuations. Dividend payers were hit hard when interest rates rose over the past two years, and investors moved back to fixed income instruments for yield. So, you have attractive valuations in dividend stocks as well.
Beyond the U.S., we are seeing reasonable valuations and opportunities in emerging Asia. China continues to be a bit of a wild card in their stimulus efforts and when they will play out, so we may not have a clear catalyst, but the valuations are attractive, nonetheless. The same can be said about European equities, where we are seeing attractive valuations coinciding with a bottoming of economic conditions.
How should investors think about risk and diversification in their asset allocation?
In the short term, while we wait for inflation to be quelled, you could see windows where both stocks and bonds fall. Not to the extent of 2022, when you had fixed income down double digits. However, negative performance is a possibility until we get to the other side of the Fed tightening program.
From a longer-term perspective, in five years, we think investors will be happy that they increased fixed income allocations, as yields are unlikely to rise materially from here. We believe that bonds will act as that negatively correlated diversifier with equities in the future.