Investors chasing attractive returns by piling into riskier equities this year face a reckoning if the Federal Reserve follows through on warnings of higher-for-longer interest rates.
(Bloomberg) — Investors chasing attractive returns by piling into riskier equities this year face a reckoning if the Federal Reserve follows through on warnings of higher-for-longer interest rates.
After lagging behind the market in 2022, stocks that are generally more volatile have outperformed this year as corporate earnings held up better than feared and worries of a recession abated. Bloomberg’s factor analysis, calculated on a net long-short return basis, shows low volatility is the worst-performing strategy so far this year for the MSCI World Index.
“Investors are prepared to embrace slightly poorer quality stocks right now as they see a lower probability of a hard landing and that’s encouraged them to take on more speculative value options,” Ed Rackham, co-chief investment officer at Los Angeles Capital Management, said in an interview.
But that trend could see a stark reversal if the Fed elects to keep raising interest rates to quell stubbornly elevated inflation against the backdrop of strong economic growth. In a sign of persistent investor nervousness, global stocks were roiled Friday by liquidity concerns in the US banking sector as portfolio losses prompted SVB Financial Group to attempt a hasty fund raising. Unexpectedly hawkish comments by Fed Chair Jerome Powell this week have also dented risk demand.
Wells Fargo Securities LLC strategist Christopher Harvey said he expects higher-risk stocks to see volatility in the near term as the market faces a “unique, idiosyncratic risk” from fears of a run on SVB Financial.
Over at Abrdn, Investment Director James Athey said that with the US yield curve inverted to an extent not encountered since the early 1980s, “the improvement in data we’ve seen recently is more a reason to sell equities than it is to buy given the pressure it puts on the Fed to be even more aggressive in hiking rates.”
The latest figures painted a mixed picture of the US labor market as payrolls rose by more than expected, while a broad measure of monthly wage growth slowed. Still, the hotter-than-expected increase in jobs is likely to pressure the more cyclical parts of the market, because they house the bulk of the lower-quality, higher-volatility stocks.
And while prospects of a recession have been receding, strategists including those at JPMorgan Chase & Co. and Bank of America Corp. say the economy tends to show the impact of rising rates with a lag. That potential downturn could revive the S&P 500 Low Volatility Index, which has underperformed the benchmark gauge by nearly eight percentage points in 2023. The rally in nonprofitable technology stocks, on the other hand, would be at risk of fizzling out.
“Picking up high-caliber companies at a depressed valuation is never a bad thing, but there are risks involved,” said Sophie Lund-Yates, lead equity analyst at Hargreaves Lansdown. “Broadly speaking, markets have priced in a moderate recession, but anything beyond that will be met with further falls. We’re not yet at a point where high-risk-high-reward investing is the best step to take.”
(Updates with context on SVB Financial and comments from Wells Fargo strategists, starting in the fourth paragraph.)
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