Moneycontrol Pro Panorama | Did Powell rock the boat?

The conundrum for the Fed members is that the US economy’s resilience to high rates is slowing the descent of inflation towards the central bank’s target of 2 percent.

Dear Reader,

It was not the US Federal Reserve’s decision to retain benchmark rates at 5.25-5.5 per cent (a 22-year high) that turned global equities nervous. But it was the hawkish commentary with warnings that the battle against inflation could be longer than earlier forecasts that cracked the rising trend in global equity indices. Besides, it signalled one more rate hike in 2023.

The Asian indices opened weak taking cues from Wall Street that tumbled to close lower on Wednesday.

But did the Fed rock the boat? Not quite. Note that inflation has been cooling off and unemployment rates are rising, which gives policy makers comfort to pivot. The knee-jerk reaction by investors was perhaps from Fed chair Jerome Powell indicating that rates may be “higher for longer”.

The conundrum for the Fed members is that the US economy’s resilience to high rates is slowing the descent of inflation towards the central bank’s target of 2 percent. At 4.35 per cent core CPI, there are risks from the surge in oil prices and a relatively lower-than-desired increase in unemployment rate. The median forecast for the Federal funds rate is 5.1 per cent by year-end vs 4.6 per cent estimated in June. This implies that there would be no near-term relief from elevated borrowing costs. (Please read this FT article specially for MCPro subscribers).

The question most analysts and economists are raising is whether the Fed is being overly cautious. Inflation has been cooling off and economic activity while resilient is slowing. If things continue in this direction, there may be little need for further rate hikes. In this case, the equity market’s negative reaction may be a short-term one.

From the perspective of Indian equities, the correction could be a welcome one, given that indices have been scaling new peaks over the past few months. Valuations are at a premium to historical averages. Clearly, earnings need to grow more than expectations to justify high valuations and create a “new mean”. But, given high oil prices and food inflation and the high base of the last two quarters of FY2023, earnings growth may moderate in the coming quarters.

What’s more intriguing is that the mid and smallcaps, which are usually first to tumble during negative news, are holding up. Flows were disproportionately captured by mid and smallcaps and at the index level, these buckets moved up by 33-35 percent in 5-6 months, explains Anubhav Sahu in this article. Therefore, the risk-reward in terms of investment style is tilted in favour of largecaps.

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Vatsala KamatMoneycontrol Pro