Volatility declined last week, although it remains above its long-term average, as the market digested the first monetary tightening from the US Federal Reserve since the pandemic.
Last week, Fed Chairman Jerome Powell released further commentary on the likely path for interest rates. His comments suggest that the tightening path for the US could be steeper than expected, with a rate hike of 50 basis points (0.5%) possible next month.
The market now sees a better-than-even chance that this will be the case. In fact, markets now think the Fed could likely hike by 50 basis points in May and then again in June. That could leave us with a Federal Funds Rate as high as 2.25% to 2.5% by the end of this year (it was effectively zero at the start of 2022).
This is a major upgrade from the expected 1.9% year-end level policymakers were forecasting a few weeks ago.
For an explanation of what is going on, look no further than the inflation numbers. Consumer prices continue to surprise to the upside, with hot inflation data showing continued price rises for consumers around the world. Further, these most recent inflation data do not include the likely impact from the Russia-Ukraine war, which has pushed up commodity prices even further.
Higher inflation expectations in markets will typically manifest as higher interest rates demanded on corporate debt, which we have started to see in recent weeks.
Hot inflation also puts the world’s central banks in a bind. Do they wait and see whether inflation will come back down, cooled by a major supply side response to high prices? Or is the right solution to act early and tame inflation with higher interest rates?
So far, the policy of central banks has been very much the former. Wait and see, then hope the global supply response to higher prices tames inflation.
In the meantime, rather than betting on the outcome, investors should be focused on ‘weather proofing’ their investment portfolios to achieve solid returns, through higher or lower inflation, higher or lower interest rates. In our view, this means a relentless focus on valuations and gaining exposure to structural growth themes which are indifferent to macro-economic outcomes (clues: the energy transition, urbanisation, ecommerce adoption, et al.).
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