iCapital Market Pulse: Markets unsure of Powell’s path to a “Soft-ish Landing”

The markets initially reacted positively to yesterday’s press conference by U.S. Federal Reserve (Fed) Chair Jerome Powell. There were no hawkish surprises, the committee said it was not actively considering a 75 basis point hike, and appropriate Fed rate hike expectations had already been priced in, especially at the front end of the curve.¹ Combined with low positioning, extremely bearish sentiment, and the resumption of corporate buybacks as earnings season tapers off, investors appeared to anticipate a near-term rally. The chair had looked to reassure markets that there is a “path to a … soft-ish landing,” by striking a balance between addressing inflation and maintaining reasonable economic growth.²
 
Investors clearly don’t share Mr Powell’s optimism, as markets slumped heavily today.³ Elevated market volatility appears entrenched in the short-term. Nevertheless, there are three things that we would buy in the current valuation and market environment.

1) Oversold tech stocks
We flagged last week that the valuations of select semiconductors, software, and communication services stocks have fallen towards five-year lows.⁴ Many of them are technically oversold.⁵ Many of them have expected 2023 to 2025 earnings per share growth in excess of 10%.⁶ Furthermore, recent earnings reports highlight that activity in software, cloud computing and semiconductor end markets remains strong.⁷ Importantly, many of these stocks have volatility around the 90^th percentile of their five-year ranges.⁸ These are the stocks that we would be looking to buy right now and/or sell a put option on them to monetize their elevated volatility.

2) Short-dated municipal bonds
With markets seemingly pricing in an appropriate number of rate hikes, we expect the front end of the U.S. Treasury curve to be more stable. The three-year U.S. Treasury yield is now 2.817%, but another way to position here is to look at short-duration municipal bonds (munis), with three-year AAA munis yielding 2.38% or almost 4% taxable equivalent yield.⁹ With low duration risk and the highest yield since fall of 2018, munis can help anchor a portfolio in a still uncertain environment.¹⁰ The relative value of munis versus Treasuries is also now attractive: the ratio of muni yields to Treasuries in the three-year part of the curve is 0.84, up from 0.34 to start the year.¹¹

3) Add to income-producing fixed income and alternatives
With the Fed less hawkish than feared and the details of the balance sheet runoff unveiled, we also have a bit more confidence in adding to other parts of fixed income. As highlighted two weeks ago, we would be adding to U.S. high yield, which now has a yield-to-worst of over 7%.¹² With the economy still expected to grow 3.2% this year and default rates in check, publicly traded leveraged loans and private credit are also good places to be.¹³

These three ideas span the risk spectrum. The Fed is struggling to strike a balance between being decisive but not overly aggressive. As investors we also need to strike a balance between taking calculated risks (in places like tech stocks) and adding more certainty to portfolios (through income) in a still-precarious environment. Fortunately, the valuation and yield environment is finally presenting opportunities for us to do so.