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The Tell: Fed is the market’s biggest risk as stocks and bonds stumble together, says Citi

With both stocks and bonds struggling in 2022, the Federal Reserve is the market’s biggest risk as it tries to fight inflation with “mighty” tools that are “lacking in subtlety,” according to a midyear outlook report from Citigroup’s wealth-management business.

Investors are now trying to gauge whether the U.S. economy is going through a period of slow growth that avoids contraction, or heading for a recession triggered by the Fed tightening its monetary policy too much to combat high inflation, said David Bailin, chief investment officer for Citi Global Wealth, in a phone interview.

“There’s uncertainty about those two outcomes,” said Bailin. “What we are doing is focusing on creating a resilient equity portfolio.”

Citi likes stocks that are larger and pay dividends, as they typically hold up better in a down market and tend to perform better when markets recover, according to Bailin. He said Citi also has exposure to health care through pharmaceutical stocks because of their “relatively” low valuations, high dividends and tendency to fare well in any economic environment.

In its midyear outlook, Citi said it expects the economic expansion can continue if the consumer remains strong and the Fed can “moderate its current aggressive stance against inflation.” The next reading on inflation, as measured by the consumer-price index, is due out Friday morning.

“I don’t expect this to be a good print,” said Bailin. It may “look pretty bad,” he said, citing concern over higher energy prices stemming from the Russia-Ukraine war.

West Texas Intermediate crude
CLN22,
-0.21%
,
the U.S. benchmark for oil prices, settled Wednesday at a three-month high of $122.11 a barrel. That’s up from around $75 a barrel at the end of 2021 based on front-month contracts
CL.1,
-0.22%
.

“Oil at these prices is obviously a tax on the consumer,” Bailin said. “Paying five dollars a gallon for gasoline means they can’t buy other things.” 

Gas prices in the U.S. averaged $4.955 a gallon on Wednesday, up from around $3 a year ago, according to AAA Gas Prices. In California, gas prices were even higher, at $6.39 a gallon on Wednesday.

Consumers, under pressure because of inflation, are pulling back on discretionary spending versus buying “durables,” said Bailin. “We have in our portfolio a major tilt toward durables.”

CITI GLOBAL WEALTH INVESTMENTS MID-YEAR OUTLOOK 2022 REPORT

“Discretionary consumer spending is likely the economy’s most vulnerable component, and only while rapid inflation lasts,” Citi Global Wealth said in the report. “More spending power is going toward putting food on the table, heating and cooling homes and fueling cars,” said Citi, with “less to spare for discretionary items from meals out to gadgets to overseas trips.”

Inflation may have risen last month, but that’s not necessarily indicative of the long-term trend of where it’s headed, according to Bailin. The consumer-price index rose 0.3% in April for a 12-month pace of 8.3%, slowing from an annual rate of 8.5% in March. In its report, Citi said it expects U.S. inflation will fall toward 3.5% in 2023.

Bailin sees excess inventories at Target Corp.
TGT,
-0.45%

as a sign that supply is coming back at the same time that demand is falling for goods, meaning supply-chain problems that led to higher prices in the pandemic may no longer be “an issue for large parts of our goods-oriented economy now.” He said some parts of high inflation may be resolved by supply and demand “naturally coming together.” 

CITI GLOBAL WEALTH INVESTMENTS MID-YEAR OUTLOOK 2022 REPORT

But some of the jump in cost of living in the U.S. is “circumstantial,” said Bailin, explaining that the Russian-Ukraine war has led to a rise in prices of agricultural commodities and energy.

Read: Russia-Ukraine war prompts Citi CIO to make these changes to stock-market allocations

That limits what the Fed can do to rein in inflation, he said. “The Fed can only destroy demand.” 

In seeking to combat inflation, the central bank is trying to cool the economy by raising interest rates and shrinking its balance sheet by letting bonds it bought roll off under a program known as quantitative tightening. 

Quantitative tightening is “the reversal of its easy credit policies that ensured the flow of capital as the pandemic struck home in 2020-21,” Citi said in its report. “If the Fed hikes rates too high, too fast while also reducing market liquidity, a recession can ensue.”

Bailin said that “right now, they’re acting very aggressively, and that’s got the stock market spooked.”

The Dow Jones Industrial Average
DJIA,
-0.58%

is down more than 9% this year through Wednesday, while the S&P 500
SPX,
-0.83%

has dropped almost 14% and the technology-heavy Nasdaq Composite
COMP,
-1.12%

sank nearly 23%, according to FactSet data.

“We’re nibbling now” in the tech sector, where Citi is assessing a “huge opportunity” to find companies with “substantial revenue growth” that are trading around valuations seen before the pandemic in 2019, said Bailin. He said Citi also likes stocks in cybersecurity and fintech as those are areas where companies will be spending money over the next decade. 

Within equities, “our only cyclical exposure is to commodities,” said Bailin. He expects “there’s still a lot of profit to be made by companies that are both refining and producing” necessary commodities.

‘Bonds are back’

After their selloff this year, “bonds are back,” said Bailin. While the jump in interest rates has hurt their value in 2022, the rise in yields may be peaking, he said, adding that bonds may once again provide diversification and income to portfolios.

While Citi is not expecting a recession this year under its base-case scenario, it’s also being cautious within fixed income, preferring “quality-oriented” bets such as U.S. investment-grade bonds as opposed to reaching for yield in riskier credit, according to Bailin. 

Citi is underweight developed market high-yield debt, its midyear report shows. Owning high-yield bonds may be risky with the Fed withdrawing “liquidity from the market,” said Bailin.

“We do not want our clients to take credit risk at this point because that could be the surprise,” he said. “If things go poorly, credit risk could turn out to be a bad trade.” 

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