The Fed Went Big: Three Key Implications for Asset Allocation
The Federal Reserve has finally made a pivotal shift. After two years of interest rate hikes, it is transitioning from a restrictive policy stance to a more neutral one.
Although this policy shift was widely anticipated, its importance for the global economy—and for asset allocation—cannot be overstated. In this article, we share three ways that this critical turning point in the interest rate cycle impacts investor portfolios.
Reinvestment risk is now an investor’s worst enemy
Though higher rates have been a primary cause of economic uncertainty and slowing growth in recent quarters, they’ve also provided an important source of investment income. Now, with lower policy rates, the landscape for income generation across risk assets will shift.
Investors are already moving to lock in higher interest rates before they’re no longer available. Money market flows have begun to reflect rate cut expectations as of the start of 2024. We expect this repositioning to accelerate now that the interest rate-cutting cycle has begun—and accelerate even more as the yield curve normalizes.
What can investors do to avoid reinvestment risk? Within fixed income, investors can consider pivoting from cash-like securities and into short-duration corporate and municipal bonds, and adding duration in the upward-sloping municipal bond curves. Though credit spreads are likely to widen as economic growth slows, holding bonds to maturity can result in opportunities in both price appreciation and income generation.
Though it may be too early for wholesale profit taking in equity, high valuations mean investors may consider taking equity-like risk in credit, which offers better carry opportunities via coupon income.
Good news is now good news, and bad news is bad
The fact that the Fed is cutting rates sends a powerful economic signal: A reacceleration of inflation is no longer the primary risk on their list. Instead, concern about the labor market is driving the pace of policy normalization.
This tipping point in the data has already meaningfully changed the way the market interprets economic developments. Where good news for the economy once threatened further Fed hikes, it now consoles investors that a recession has not yet arrived. In other words: Good news for the economy is now good news for the market, and bad news is bad.
The market’s concern about growth has made it even more reactive to economic data. Investors should expect to get whipsawed in risk posture, market leadership, and duration until signs of an economic slowdown are clearer.
Periods of high volatility—in both directions—provide investors with a valuable opportunity to rebalance towards more durable economic themes. Cyclical asset classes will have their days in the sun, but we don’t expect sustained outperformance until the economic cycle reaccelerates. Instead, investors can focus on quality: strong earnings, free cash flow, and durable equity themes tied to capital investment in digitalization, electrification, and supply chain re-globalization. They can identify sectors—such as real estate equity—that have consistently outperformed as rates have fallen.
A normalizing yield curve unlocks frozen capital
Finally, rate cuts historically mark the first step in normalizing an inverted yield curve. Since an inverted yield curve cuts credit supply to the real economy, a normalizing yield curve should improve it. Importantly, a shift in credit supply could unlock previously frozen capital, reinvigorating investment and borrower health
What’s more, if economic growth stabilizes in the early stages of this rate-cutting cycle, then rate cuts may come more slowly than in the past. In our view, this could extend the valuation “bottoming” process in many asset classes, creating an opportunity for debt and equity to perform at the same time. Expanding on this theme: While higher rates have recently favored debt investments, a transition towards moderate rates, controlled inflation, and more sustainable growth rates may signal a promising environment for both borrower health and equity return potential across private and public markets.
For further insight into the impact of macroeconomics on portfolios and high conviction asset allocation ideas, visit https://www.newyorklifeinvestments.com/global-markets.
Lauren Goodwin is the Chief Market Strategist at New York Life Investments. She leads the firm’s Global Market Strategy team, which is responsible for economic and market commentary, asset allocation, and thought leadership.
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“New York Life Investments” is both a service mark, and the common trade name, of certain investment advisors affiliated with New York Life Insurance Company. *Assets under management (AUM) includes assets of the investment advisers that make up “New York Life Investments” as of 6/30/2024. AUM includes certain assets, such as non-discretionary AUM, external fund selection, and overlay services, including ESG screening services, advisory consulting services, white labeling services, and model portfolio delivery services, that are not necessarily considered Regulatory Assets Under Management according to the SEC’s Form ADV. AUM is reported in USD. AUM not denominated in USD is converted at the spot rate as of 6/30/2024. The total AUM figure of “New York Life Investments” is less than the sum of the AUM of each affiliated investment adviser in the group because it does not count AUM where the same assets can be counted by more than one affiliated investment adviser.
