Financial conditions is key to understand the current rate regime
The current inflationary pressures are a complex mix of global supply constraints in logistics and manufacturing out of China, excess fiscal stimulus during the pandemic, a decade of underinvestment in metals and energy, and now the war in Ukraine. When inflationary pressures are driven by the supply-side of the economy and fiscal stimulus is still high then the only way for the central bank to ease inflationary pressures it to cool demand. This is what the Fed is planning to do quickly through hiking interest rates and tightening financial conditions.
Financial conditions have already tightened a lot recently without the Fed reducing its balance sheet or hiking the Fed Funds Rate (see chart). Since 1971 the correlation between financial conditions and the Fed Funds Rate has been 0.6, but since 2003 it has effectively been zero suggesting financial conditions are an entirely different thing compared to the past. This is crucial for updating the prior that the current hiking regime is good for equities. With financial conditions already tightening before the aggressive rate hikes have begun (the low correlation at this point), the rate of change and level in which we will see in financial condition could be something we have not seen since the financial crisis in 2008 if the Fed hikes by 50 bps in May and June. The Chicago Fed Adjusted National Financial Conditions Index is right now at -0.25 which means that as of 11 March financial conditions in the US were still looser than average given economic activity. Date since 1973 suggests that as financial conditions move above 0.5 then it becomes a negative factor for equity returns and this is where it gets interesting vs the higher Fed Funds rate equals positive equity returns. If financial conditions tighten a lot as a function of many things including Fed hikes then this rate cycle will not be like the historical average, quite the contrary. Our concluding remarks are thus that we are still defensive and prefer equity themes that have momentum and will do well in the current regime (logistics, cyber security, defence, and commodity sector – we added green transformation to this group yesterday).