The biggest question in markets today is whether the Fed will be willing to crush inflation even it means weaker equity markets. Rates markets do not think they have the resolve. They are pricing the Fed to hike rates to around 3.25% and then give up even with inflation meaningfully above the Fed’s 2% target. We think markets could be wrong and the Fed goes further – raising rates to at least the pre-global financial crisis (GFC) levels of 5.25% or even 8%.
Even if we are wrong on the terminal rate, but right on the balance of risks for the Fed, it means there is still more downside to risk markets like equities. Therefore, the late equity surge in May that helped equities deliver a flat return for the month is likely to be temporary (Chart 2). Higher yields means lower price-earnings ratios and weaker growth prospects. We remain underweight equities.
The crypto markets will also be affected by this backdrop, and we are discovering specific vulnerabilities especially with the Luna/TerraUSD debacle. As a result, the last month (May) saw terrible performance in crypto with bitcoin down 18% and Ethereum down 31% (Chart 2). The YTD Sharpe ratios of crypto have now fallen to similar levels as equities. We published extensively around this unwind and further stablecoin weakness and therefore switched to a neutral position during the month (from overweight). We stick to being neutral.
As for the rest of markets, we stay short bonds especially given our Fed view and stay overweight commodities on poor supply dynamics. And of course, we like to be overweight cash. As wrote in our previous asset allocation update, when markets are fragile, preservation of capital is paramount, and cash is king.
Finally, in terms of equity sectors, here are our favourite views:
Within US, we like to be overweight financials, homebuilders, large cap value, reopening trades, semi-conductors, traditional infrastructure and underweight large cap growth, communications, consumer discretionary, materials and technology.
Bilal Hafeez is the CEO and Editor of Macro Hive. He spent over twenty years doing research at big banks – JPMorgan, Deutsche Bank, and Nomura, where he had various “Global Head” roles and did FX, rates and cross-markets research.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)
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