If The Fed Pauses/Cuts, What Could Rally?

Main Thesis & Background

The purpose of this article is to discuss the broader market with a focus on what may perform well in this upcoming year if the Fed backs off its aggressive rate hiking approach. That is a big “if”, since the Fed appears set to raise rates early this year when they meet again. But in my opinion that may be the last of it. I see the Fed nearing the 5% mark and then pausing to give some time to assess its impact on the markets. In 2022 the Fed was in a “hike and don’t look back” mode and kept on its path without much thought on the impact. As the year ended, it shifted to a .50 basis point hike which gives an indication it is starting to respond to macro-events.

It is on that basis that I believe the Fed will not be raising rate post-second half of 2023. I differ with the market because I do not see Fed cuts on the horizon until at least next year (so participants believe a cut could be in the cards this year). But I want to examine some areas that could perform well if the Fed is almost done raising rates and/or begins a more accommodative style.

Is The Fed Done? The Market’s Outlook Is Mixed

Let me start with a discussion on how likely it is the Fed may shift to a dovish policy. As I said, I think a “pause” is the next step – but some investors believe cuts are on the table sooner than later. This outlook is a bit too optimistic for me, but I will sit here and say nobody knows for sure what 2023 will ultimately bring. So considering that possibility makes sense.

In this vein, we should recognize that just under half of market participants surveyed recently see the Fed cutting its benchmark rate at some point this year. This skews heavily towards the end of the year, but 2023 nevertheless:

What is very telling here is that many people that do not see a decrease this year, still expect one by Q1 2024. Heading in to this year, that is not what I would have expected. I would place myself in the 18% group that expects Q2 2024, or later.

But I have been wrong before, and I will be again. Many investors clearly expect the Fed to be more accommodative within the next 12 – 15 months. While that seems optimistic for me, I may be missing some in a big way. As a result, it is making me contemplate how I should position part of my portfolio in the event the Fed does surprise me. In the following paragraphs, I will suggest some investment options that should do well if that scenario does occur.

What Performs Well Post-Rate Hike Cycle? Real Estate For One

One area that has been top of mind for me has been Real Estate. This has been driven for two reasons:

1. The sector performed terribly in 2022

2. REITs tend to perform well when inflation is modest and/or on the decline – which is what I expect in 2023.

So I went in to this year thinking Real Estate could be due for a rebound, and the potential for Fed easing at some point this year adds a third bullet to that list.

For support, let us consider historical performance. While REITs have generally underperformed equities during rate hike cycles (i.e. 2022), REITs will often out-perform the S&P 500 in the 3, 6 and 12 month time periods after such increases have concluded:

History is very straightforward here. REITs have a track record of out-performance and strong gains when a rate hiking cycle ends. I saw some bullish momentum building for this sector before even taking this in to account, and now it seems like a no-brainer. If one surmises the Fed is nearing the end of its current path, then a move into Real Estate should be a winner.

For a more in-depth discussion on this sector, please read my recent article on the Schwab U.S. Dividend REIT ETF (SCHH).

*I think investors could be well served within this sector by looking at passive ETFs such as SCHH or the Vanguard Real Estate ETF (VNQ). For sub-sector specific exposure, I think self-storage units and apartment REITs in particular. I have a personal holding in Mid-America Apartment Communities Inc. (MAA).

Growth Has Been Hit Hard, Potential For Rally

A second area that looks poised for a rebound this year is “growth”. Similar to Real Estate, this thematic play took a beating last year. Growth heavy plays, including the NASDAQ, “Growth” ETFs, and even the S&P 500 to a degree, were all down by large numbers.

Comparing growth vs. value is often a useful exercise, and we see that while stocks were down as a whole in 2022, growth was the laggard. The value index held up reasonably well, while the market’s growth index was down in the 30% range, as seen below:

Now, under-performance one year does not automatically translate to out-performance the following year. These trends can often have multi-year implications, but I see growth with some potential due if the Fed “blinks”.

In my personal opinion, I think value is the right move for the next few quarters until a Fed easing cycle becomes more realistic. But this review is about what could happen if the Fed surprises markets sooner than expected. In this light, growth is poised for a big rebound if the Fed gets more accommodative because the sector has been pained by the aggressive cycle. A shift in the other direction could be a big win for growth and the Tech sector. This is something readers should consider when allocating their cash for 2023 and 2024 as well.

*I own and have been adding to my version of growth, which is the Invesco QQQ ETF (QQQ) on days when declines are 1% or greater. Other options that are strongly correlated with this fund are the Schwab U.S. Large-Cap Growth ETF (SCHG) and the Vanguard Growth ETF (VUG). One could also play this theme directly through the likes of FAANG, Tesla (TSLA), or Consumer-oriented funds like the Consumer Discretionary Select Sector SPDR ETF (XLY).

Other “Risk-On” Assets Would Have Merit

I will now dive in to some alternative areas readers could consider, but I want to be abundantly clear that these are riskier ideas and therefore not appropriate for everyone. The first is a classic example – crypto – with the two largest currencies being Bitcoin (BTC-USD) and Ether (ETH-USD). I do not have a position in either one, and I am not really “recommending” them here. But what I am suggesting is this is an area that could see a pop if the Fed pumps the brakes in mid or late-2023.

This is not meant to sound contradictory. If I see a chance for a pop, why not buy it? Simply because I do not believe the risk-reward proposition is right for me. This reverts back to investors need to know their own risk tolerance, goals, and ability to withstand short-term losses. For me, this isn’t the right move, but 2022’s performance for these assets does show they may have bottomed out.

For example, with inflation running rampant and the Fed raising interest rates, both BTC and ETH took it on the chin:

The conclusion I draw here is that these two crypto assets have plunged for some very specific reasons: inflation, Fed hiking, FTX bankruptcy fallout.

These are all issues that may subside in 2023. The Fed may be at the end of its hiking cycle, inflation appears to be peaking, and FTX will exit the news eventually. With those headwinds subsiding, it makes sense that crypto could find some buyers again. In my view, 2022 shows perfectly why many investors would do well to avoid this arena simply because the risk is so great. But for those who are risk-on and want the action, these currencies have potential.

Energy Will Continue To Be A Winner

Another sector I continue to like going forward is Energy. This is not necessarily a Fed-pause play, but I do see the sector benefiting from such an action. If the Fed’s next move is dovish, that is beneficial for economic growth and demand for oil and energy use as a whole should increase. So there is some relevance here for this sector.

Beyond that potential, I think the Energy sector is poised for continued gains in Q1 for a few reasons. The China re-opening story is helping to balance the demand outlook that is being pressured by recession worries in the U.S. and Europe. Further, a mixed Congress in the U.S. will limit major changes to energy policy. The sector has done well since 2021 began and the status quo is probably the best case for investors here. Finally, Q4 earnings are going to be out soon and expectations are the sector has continued to be a leader in earnings growth:

As you can see, energy is poised to see the strongest growth in Q4 earnings. This is directly related to the rise in crude oil and natural gas prices, which increased 7.2% and 13.7% year-over-year, respectively, in Q4. The sector is unique in that it offers an inflation hedge, but can also benefit from Fed easing if that leads to an uptick in demand. So I see a win-win scenario here that investors should continue to have exposure to.

*I own the Vanguard Energy ETF (VDE), the Invesco S&P 500 Equal Weight Energy ETF (RYE) and ProShares Ultra Bloomberg Crude Oil (USO). I would suggest investors consider these, any number of diversified ETFs within the space, and the oil majors directly.

Bottom-line

The market has been off to a good start in 2023. The opposite was expected by a lot of people so a fear of missing out play could sustain this rally. Looking ahead, however, there are challenges that investors need to weigh before getting too bullish on stocks. These include slowing economic growth and a possible recession, continued Fed rate hiking, and corporate earnings pressure coupled with job cuts.

That is the bad news. The good news is some of these headwinds could force the Fed to back off its hawkish policy approach. While I believe the Fed will hike one more time and then pause, many investors are counting on a cut before the end of the year. The Fed’s “Dot Plot” shows there is quite a bit of uncertainty regarding the benchmark level over the next few years:

What this says to me is that investors need to be prepared for either scenario. I have laid out a few beaten-down sectors that are probably due for a push higher, especially if the market is right about a dovish Fed. While buying on this idea today may be a little early, I would suggest beginning to plan for a Fed pause/cutting cycle at some point in 2023 (that doesn’t mean it will happen in 2023, but for investors to make a plan in 2023).

I am hopeful this review gives food for thought on how to capitalize on Fed action or inaction this year, and wish readers a safe and healthy start to 2023.