The Fed’s Dilemma
At the March policy meeting, the Fed’s FOMC raised the Fed Funds Rate (FFR) by 25bps to 4.75-5.00%, in line with market forecasts. The terminal rate on its dot-plot remains unchanged at 5.1%, i.e., one more 25bp increase. It is arguably one of the most consequential meetings in the recent history as on one side, inflation remains well above the Fed’s 2% target amid continued strength in the US job market. On the other side, the ongoing banking crisis in the US and Europe is a major concern as it could pose a threat to global financial stability. What is of greater significance is that the banking crisis, controversially, has been induced by the Fed’s aggressive monetary policy tightening.
The Fed is facing the major policy dilemma: a) continue to focus on inflation and continue with the “ongoing” monetary policy tightening; or b) refocus on the financial stability risk and pause the monetary policy tightening or even cut the interest rates.
In the meeting, the Fed has acknowledged that the recent turmoil in the banking sector has led to a tightening of financial conditions, which could potentially impact the US economy by restricting credit availability for households and businesses, as well as job and price outlook. However, the full extent of this impact is still uncertain, and the Fed has emphasised its continued focus on managing inflation risks. Despite this, the Fed Chair Jerome Powell has suggested that there may be less need for additional rate hikes as the stress in the banking sector also led to credit tightening. Thus, he foresees “some additional policy firming” as a part of policy tightening without relying solely on rate increases.
Why the Fed has to refocus on the financial stability?
The current banking crisis is severe and represents a significant systematic risk. The Fed raised interest rates from near 0% to nearly 5% in just 12 months. In response, banks were expected to adjust interest rates on consumer deposits in line with the Fed Funds Rate, which should have led to consumers earning 4.5-5% interest on their bank savings accounts. However, banks did not increase interest rates on savings accounts, prompting customers to withdraw their deposits and invest in Treasury Bills yielding 4-5%.
Furthermore, as the Fed increased interest rates, the value of bonds held by banks declined, resulting in significant losses when banks sold these bonds to fulfill customer withdrawals. These two factors have contributed to a liquidity shock, but not yet a credit crunch. Therefore, the Fed cannot continue raising interest rates as this would worsen the situation by further increasing short-term Treasury Bill yields and encouraging more deposit withdrawals. Instead, the Fed should consider lowering interest rates, which would have a dual benefit of discouraging deposit withdrawals and boosting bond prices.
Crises make strange bedfellows
Despite the recent turbulence in the banking sector, the Technology, Health Care, and Communication Services sectors have shown remarkable resilience (see the table below).
|1-week return (%)|
|S&P 500 Information Technology||5.66|
|S&P 500 Communications Services||6.94|
|S&P 500 Health Care||1.31|
|S&P 500 Financials||-6.09|
Source: Market Watch, between 10-17 March 2023
The outperformance in Technology, Health Care, Communication Services sectors is believed to be due to expectations of an earlier rate cut by the Fed. It is worth noting that established technology companies such as Apple, Alphabet, and Microsoft hold significant cash reserves, making them less vulnerable to balance sheet downturns. Furthermore, their core businesses do not appear to be directly impacted by banking difficulties, which may contribute to their continued strength. Unlike startups, these established players have established track records and more diversified revenue streams, making them less susceptible to the fallout from the current banking crisis. Finally, at the time of writing, the interest rate futures market was implying 2 rate cuts by year end, bringing the terminal rate to 4.00-4.25%. If this is true, growth-oriented sectors such as Communication Services and Information Technology are expected to benefit from this development.
What should investors do?
During times of market uncertainty, it can be wise for investors to focus on investing in high-quality companies that exhibit strong operating metrics. Industry leaders are often considered to be among these quality companies, as they tend to have a history of stable financial performance, strong management teams, and consistent revenue and earnings growth. Due to their robust fundamentals, these companies are better equipped to navigate economic downturns and other challenges, making them a potentially prudent investment strategy for uncertain markets.
The PGWA World Leaders is a discretionary portfolio designed for long-term investors seeking capital appreciation growth over an extended period. The portfolio applies a modified Hockey Stick Strategy, which focuses on the performance of the world’s largest companies in their respective industries. To identify companies with strong revenue growth potential, the portfolio uses the “Rule of 40,” which requires revenue growth rates plus profitability margins to be equal to or greater than 40%. Additionally, the portfolio uses qualitative screenings to evaluate a company’s performance, including its revenue size, debt capacity, capital expenditure, past R&D investment, productivity improvement, and differentiation improvement.
The fund invests in companies that are leaders in their respective industries, which are listed on the US stock market. A semi-annual rebalancing is conducted to capitalise on market trends and opportunities while reducing the impact of market volatility on its performance. This approach ensures that the fund’s investment strategy stays aligned with its objectives and optimised for returns. Investing in companies that are industry leaders can be a way to gain exposure to a particular sector while mitigating risk. These companies often have a competitive edge over their competitors, demonstrated by their dominant market share, strong brand reputation, and successful track record. By investing in these industry leaders, investors can potentially benefit from their strong performance and stability, hence reducing the overall risk in their portfolio. Apart from its heavy weighting in high growth industries such as Communication Services and Information Technology sectors, the fund also invests in Health Care which is recession-proof and less vulnerable to economic downturns.
Top 5 Holdings
|Company||Sector||Region||% In the Portfolio|
|META PLATFORMS A||Communication Services||US||12.28|
|NOVO NORDISK-B||Health Care||Denmark||9.90|
|TAIWAN SEMIC-ADR||Information Technology||Taiwan||9.17|
|BIONTECH SE||Health Care||Germany||9.13|
|MICROSOFT CORP||Information Technology||US||8.76|
Source: PCM, as at 28th February 2023
Top 5 Sector Holdings
|Sector||% In the Portfolio|
Source: PCM, as at 28th February 2023
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