The market anticipates about seven rate hikes this year, beginning in March with at least a quarter point hike. But exactly how fast the Fed raises rates will depend on how the economy is doing.
“The Fed has two basic tools – rates and the balance sheet,” said Lowe. “Through the pandemic they were buying treasuries and mortgages. That’s going to end in March. And then they’re going to start shrinking their balance sheet – quantitative tightening. That will also work to push up rates.”
Despite the uncertainty and volatility of the current environment, Lowe doesn’t view the market outlook negatively. “Markets can and have performed well during Fed hiking cycles because the Fed is generally hiking when the economy is strong. So, we expect solid returns but more muted than the past two years when we had outstanding returns.”
Added Royal: “Since the 1990s, in periods when the Fed is hiking rates, the markets have typically dropped a little bit and then actually outperformed over time. If recent history is any guide, the next six months after a rate hike cycle could be challenging, but long term, it could be a good time to be in equities.”
Stock market prospects
Different types of stocks can lead the market during different periods in the economic cycle. “During a recession, you have low growth, low inflation, maybe even deflation,” said Royal. “During those times, you want to be in defensive, low beta, low volatility areas, such as large caps, which generally carry less risk and less leverage than small caps.
“As you move into that recovery phase,” he added, “it can be a little counterintuitive. The types of stocks that tend to perform well in that phase are the riskiest stocks, cyclicals, deep value, high beta, low quality companies with high leverage, negative earnings, or poor credit ratings, including small and even micro caps – and we saw that in spades in the first quarter of 2021.”
The economy very quickly moved out of that recessionary phase into the recovery period. “The recovery period is when the economy is still growing but growth is decelerating, and inflation is picking up,” said Royal. “At that stage of the economy, you may want to be in some higher quality names but still cyclical value, defensive value, and areas with growing earnings. You may also want to move up in market capitalization during this period.”
Entering a slow-down phase, Royal believes investors should consider moving to the higher quality, growth momentum, longer duration segment. “As we see signs of economic slowdown – and we will at some point – that’s when you would want to move toward large cap names – like growth and technology. And then to finish the circle, you would want to get a little more defensive as you start to see the economic slowdown progress and perhaps even accelerate.”
The recent market sell-off was led by small and mid-cap stocks, many of which dropped 40% or more. “I view periods like this as an opportunity to buy great growth-oriented companies that are going to benefit from the next phase of the cycle because the sell-off was so indiscriminate,” said Royal.