Why a hawkish Fed could see less glamourous end of the equity market take centre stage

The S&P 500 had its best week since February last week, and the S&P 500 reached a fresh record. The Nasdaq rose by more than 1% on Friday, and growth and value stocks moved higher in unison, which suggests that the Santa rally is finally here. There’s only one catch, the much-anticipated Fed meeting takes place this week, and after annual inflation came in at 6.8% last month, there is high expectations that the Fed will act on their recent hawkish pivot. They are expected to double the pace of tapering their asset purchases, and they may even mention the timing of interest rate increases for the next year. 

How markets react in a rate-hiking cycle 

A hawkish Fed does not mean that the Santa rally needs to hit the skids, more that traders need to be picky, as some stocks will perform better in this environment than others. Overall, stocks tend to do well in the 6-months leading up to the first-rate hike, as the economy performs well which leads to the FOMC embarking on a rate-hiking cycle in the first place. How well equities do after that depends on the pace of tightening, a fast pace of tightening, for example a rate hike at every meeting, can cause equities to struggle. However, if the Fed takes a more leisurely pace of rate hikes, for example, if they pause between meetings, this does not tend to have such an impact on stock markets. The market is currently expecting the first rate increase from the Fed at the June 2022 meeting, with more than 40% of the market expecting a 25-basis point rate hike, and nearly 30% expecting a 50-basis point hike, according to the CME Fedwatch tool. Current market expectations are for rates to potentially rise to a high of 100-125 basis points by the end of 2022, which suggests a fairly rapid rate of increases from the Fed next year. 

What to trade when the Fed tightens quickly

Current market expectations for US interest rates suggest that the market is confident that the Fed will reign in inflation, however, if the top end of expectations are correct and rates do rise to 125 basis points or more by the end of next year, then this pace of rate increases could hit economic growth. As we have mentioned in past notes, in this environment you tend to see a move away from growth stocks with a focus on only growing sales even if they lose a lot of money in the process. Instead, the market tends to favour companies that make tangible goods, who have control of their costs and companies that can innovate. As investors rush to price in a rapid pace of Fed tapering for next year, we have seen a draining of enthusiasm for the mega-growth stocks, for example Zoom, the video technology company, has seen its stock price fall more than 60% this year, and is back at its lowest level since May 2020. We think that there could be more pain for growth stocks to come, and this is why we prefer to look at these three stocks as we await the Fed meeting this week. 

1, Tyson Foods: this stock is an analyst favourite as we lead up to 2022, and we can see why. It announced plans to spend $1.3bn to automate its meat plants over the next three years, as a way to overcome the labour shortage in the US as the same time as demand is booming.  This is expected to reduce costs by $450mn over 2 years, the company said. Its plan to automate its chicken de-boning process is expected to create savings equivalent to 2,000 jobs. The important chicken unit at Tyson Foods has struggled, however it is expected to return to profitability next year and overcome its supply chain woes. This year, Tyson has slaughtered 37 million chickens a week, next year it expects this number to rise to 40 million, and to rise further to 47 million a week over time. Tyson Foods is one of our picks to outperform in an environment where the Fed is tightening because: 1, it produces tangible “stuff”, 2, it’s already innovating and 3, its profitability is expected to rise. Upward momentum in this stock is strong, and we could see a return back to early 2020 levels at $93 per share, a record high, if we continue to see a shift towards value stocks. 

2, American Water Works: This company is a component of the S&P 500 utilities sector, a sector that we expect to outperform next year. In an environment where investors are worried that the Fed will have to tighten rates at a fast clip and could threaten economic growth, then utilities will be in vogue. One thing everyone needs, regardless of the economic environment, is water waste services, which this company specialises in. Its stock price has been fairly range bound since October, however, it is currently trading around $176, the top of this range, and we believe that the new year could herald a breakout event for this stock and other utilities, as the less glamourous end of the market comes into greater focus. The 2021 high just below $190, could come into investors’ focus if the Fed sounds overly hawkish at this week’s meeting. 

3, Alphabet: Google’s parent is our tech pick this week. We think that it will weather the Fed meeting storm well due to its incredibly strong profits, which are expected to make 2021 one of its best performing years, for years! In Q3, advertising revenue at Google rose some 43%. Also, Google appears to be dealing well with the privacy changes at Apple from earlier this year, which allows customers to opt out of targeted ads. Google is more protected than other companies such as Facebook, because it owns the Android Operating system. Alphabet’s rising profitability, and return on investments, which includes start-ups in Artificial Intelligence, is also likely to boost demand for this stock. Its strong cloud business is also a good selling point for this stock now that the Omicron variant of coronavirus has boosted working from home once more. 

As you can see, if the Fed does shift to a more hawkish stance at this week’s meeting, it’s time to start looking at the less loved, and less glamourous end of the market. Afterall, chicken fillets and sewage never go out of fashion, because they are never in fashion!