Strategists Keep Faith in Stocks, View Fed-Hike Bets as Overdone

(Bloomberg) -- Markets are bracing for a pivotal Federal Reserve meeting that’s expected to lay out a roadmap for tapering pandemic-era stimulus and perhaps provide clues about the timing of a liftoff in interest rates.

The prospect of rising borrowing costs to fight inflation has roiled bonds and flattened the Treasury yield curve, suggesting a slower economic recovery lies ahead. But global stocks are near record highs, cushioned by solid company profits.

Markets are pricing in a Fed rate liftoff in the middle of 2022. Strategists suggest that may be too aggressive and are backing stocks to ride out risks, while also being alert for a hawkish tone from Wednesday’s policy decision that could stoke volatility.

Rate-Hike Pricing ‘Overdone’

“We’re of the mind that the pricing in of more than two hikes in 2022 is a bit overdone at this point in the cycle when one considers the progress still needed on the recovery before the Committee begins policy rate normalization,” strategist Ian Lyngen of BMO Capital Markets wrote in a note. “That said, we’re all too cognizant of investors’ focus on realized inflation and the collective eagerness to bring forward rate hikes into mid-2022.”

Earnings Cushion for Stocks

“We maintain our view that rates” will rise toward the first quarter of 2023,” John Woods, Asia-Pacific chief investment officer at Credit Suisse Group AG, said on Bloomberg Television. “Equity investors seem to be willing to look through the risks associated with an interest-rate hike and inflation per se and focus much more on earnings,” which suggests the most likely trajectory for markets is to remain higher, he added. 

Tapering Isn’t Tightening

“Over the course of taper, the Fed will still make available $540 billion of additional liquidity via QE between Nov 2021 to June 2022 (assuming QE is wound down by mid-2022),” Vishnu Varathan of Mizuho Bank Ltd. wrote in a note. “This is hardly tightening. In fact, it is technically not,” he added. All things being equal, “the additional liquidity is poised to support global liquidity and therefore asset market valuations.”

“The main focus will be on how the Fed manages to de-couple rate hikes from mid-2022 QE termination. This may result in restrained upside for front-end yields as markets re-assess their strident bets on a mid-2022 rate hike.”

Negative Real Yields

“U.S. equities tend to outperform bonds when the Fed is hiking rates, providing one longer-term reason for U.S. equity market resiliency as the timing of Fed rate hikes remains in focus,” Lori Calvasina, equity strategist at RBC Capital Markets, wrote in a note. “Second, negative real yields, which are close to their lowest levels post-Financial Crisis, also remain supportive of U.S. equity markets for now.”

Beware the Hawkish Tilt

“The full tapering process is expected to last eight months after which, we think, the Fed will pause before interest rate hikes are considered,” Lawrence Gillum, fixed-income strategist for LPL Financial, wrote in a note. “Meaningful deviations from that message may negatively impact markets like we’ve seen elsewhere.”

“The last time the Fed was in this position (2013), though, markets were surprised by its hawkish shift. We think the Fed learned its lesson from that episode but a surprisingly hawkish statement by the Fed on Wednesday could result in a dramatic selloff in U.S. Treasury securities as well.”

Risk of Volatility

“As time has passed and inflation has remained stubbornly too high for comfort, I believe that the members of the FOMC have lost some of their confidence in the idea that inflation is all temporary,” Nikolaj Schmidt, chief international economist at T. Rowe Price Group, wrote in a note. 

“Should the Fed be forced to take a more assertive stance on inflation, and I do expect some hints of this in the upcoming meeting, I believe that financial markets will see some increases in volatility.”

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