Fed reiterated this rate hike cycle requires different ‘blueprint’: Strategist

J.P. Morgan Asset Management Global Market Strategist Gabriela Santos joins Yahoo Finance Live to discuss the Fed's signaling on the rate hike cycle and what policy changes mean for investors.

Video transcript

JULIE HYMAN: Welcome back to "Yahoo Finance Live." We are watching the futures head higher this morning after another volatile session yesterday in the wake of Jay Powell talking about perhaps more consistent rate increases this year and really indicating the readiness to raise rates at the next meeting, which is March 15 and 16. So as we prepare for the opening bell this morning, we've got stocks heading higher, even though we saw a leg downward yesterday. So definitely, Brian Sozzi, still some digestion, if you will, of yesterday's meeting.

BRIAN SOZZI: It is amazing, Julie, just the disconnect-- this disconnect I'm picking up right now. We just had Dow's CFO on saying demand looks to be pretty solid. You know, I talked to ServiceNow CEO Bill McDermott last night. He's seeing an acceleration of demand in the first quarter. It's just so detached from what we've been witnessing in the markets of the past week. I know markets are forward looking, but still, a lot of folks telling us that things are OK out there, for the most part-- the most part.

JULIE HYMAN: Right, and so that's why the Fed does feel like it has the leeway to go out here and raise rates and roll off the balance sheet and, et cetera, make these moves that it's making. As Jay Powell, said this time is different in terms of the economic backdrop.

Markets not necessarily buying it. There have been folks, certainly folks you've talked to, folks that we've talked to together who have talked about the risk of the Fed triggering some sort of recession. It's not being priced in this morning, at least.

[BELL RINGING]

And we have the opening bell on this Thursday morning. And, you know, as we see another virtual open for the New York Stock Exchange, something else I'm reminded about, Sozz, is the fact that the pandemic is still happening. Sometimes we have seen folks up on that podium. Sometimes we have not. But that's sort of describing the unevenness that continues to persist because of omicron, because of absences as it sort of peaks at a different rate throughout the country.

That's something that the Fed also continues to keep an eye on, even as it recedes in daily life for some people. It's still something that's also affecting the economy and that Jay Powell is also talking about.

BRIAN SOZZI: Yeah, and you see it. We'll talk a little bit about it more in a second, but look at those McDonald's results, very disappointing, in large part because of, I would think, pressure traffic to restaurants because of the variant but also too higher wages, in large part being caused by the pandemic and the labor shortage.

JULIE HYMAN: Yeah, we will talk about that in just a moment. Good tease there, Sozz.

But right now let's bring in Gabriela Santos, the global market strategist at JP Morgan Asset Management. So, Gabriela, I just want to start sort of high level, what you made of yesterday and the market reaction to it and whether you think people are sort of reading Jay Powell's commentary correctly.

GABRIELA SANTOS: So I think what I read from Chair Powell is a repetition, really, of the message that the FOMC has been delivering over the past couple of months, which is that indeed they do see this as a very different cycle. They are not looking at post-global-financial crisis as the blueprint for what this rate hike cycle is going to look like.

And that makes sense, right? We just saw 2021 GDP come out at 5.7%. It was wavy as the year went on based on the pandemic, but overall resilient economy. The unemployment rate's already at 3.9%. We got there in a year and eight months. Last time it took us nine years almost to get there. And we ended the year with inflation nearly at 7%.

So it's a very, very different cycle, and the Fed is still buying bonds. That just doesn't make sense. It is time to taper QE, to start hiking, to hike more than once, and to start bringing down the balance sheet. That's what I heard from Chair Powell, which, to me, makes a lot of sense.

But I think the market kind of had a hope that maybe they were reading this wrong and Powell would give them a more dovish message, and that's not what they received. So right now investors are trying to price in, all right, so what is this new cycle going to look like? And that means some more choppy days both in fixed income and in equities. We haven't been here before.

BRIAN SOZZI: Gabriela, is it is it crazy talk when folks out there this morning-- and I've seen a bunch of them-- looking for six to seven rate hikes this year? Is that warranted?

GABRIELA SANTOS: Well, I think it's going to depend a lot on what happens with inflation. Chair Powell left it quite clear that that's really their main concern right now, even more than the evolution of the pandemic. And they see more upside risk to inflation than they had just a month ago. So we'll have to see what happens with inflation as the months go by. It'll take us some time to figure out exactly how much is transitory, how much is structural. What's the new range we'll end up? And that's why fixed income can still stay choppy because investors want to price in a whole range of possibilities.

Right now, the 10-year is up this morning another 10 basis-- sorry, the two-year is up another 10 basis points. Investors now pricing in five rate hikes for this year. So you'll continue seeing some evolution. It's not impossible to see seven or eight if inflation stays higher than expected. It's not our base case, but it's not impossible, and that's why the direction of travel for yields is still upwards.

JULIE HYMAN: And what then is the risk to economic growth? Because that appears to be the fear of some market participants, that the Fed, in being aggressive in fighting inflation, poses a risk to economic growth. And if they do, then what does that mean for your portfolio? Should people be avoiding sort of economically sensitive sectors?

GABRIELA SANTOS: No, we don't think so, and I think this is where it's really important to not overreact too much to these moves. We're still talking about raising rates from zero. Even if we did get, let's say, seven, eight rate hikes this year, short-term rates would still be about 2%, still negative in real terms, and we're talking about bringing the balance sheet down from $9 trillion.

So financial conditions are still very, very accommodative. We're not talking about stepping on the brakes for the economy quite yet, just a soft landing in the economy as the cycle matures.

So we don't want to overreact and completely sell out of risk assets like equities and high yield. We don't want to overreact and sell out of good, quality companies that have reasonable valuations, a lot of which we find in the more cyclical areas of the market, especially within financials, industrials, some consumer names as well.

But what we do want to do is take some thoughtful action here. This is a different cycle. That means the portfolio does need to look different. We need to be careful with interest-rate risk. That means being active in fixed income, shortening duration. That also means being careful with interest-rate risk in the equity market, right-- taking profit from very expensive or speculative names and reorienting them towards more discounted areas of the market.

So overall, it's about being very, very careful with concentration risk. We want to have balance this time around and a very active approach.

BRIAN SOZZI: I was thinking a little bit last night, Gabriela. There's a whole generation of folks that have entered the market over the past decade, and, by and large, they only know a land of low interest rates to this crowd that has amassed a lot of wealth in large part because of what the Federal Reserve has done, and now they see higher interest rates. Do you think that the Fed risks spooking these new investors out of the market?

GABRIELA SANTOS: So it really has been, if you think about it, it's been 14 years of abnormally low interest rates with investors never really taking seriously the prospect that rates would become restrictive at any point in the future. So indeed there's a whole generation of investors that aren't used to nonfree money.

But the reality is that we're just going back potentially to normal behavior where investors do need to take into account the price that we pay for assets, and we need to take into account the actual long-term sustainability of their cash flows, of their earnings generation. That was actually normal investing behavior before the financial crisis, and we're going back towards that period, we think.

And that really speaks to this idea of focusing on interest-rate risk, concentration risk, rebalancing, thinking about valuations very, very carefully, which for a lot of portfolios means taking profit from growth, reorienting to value, taking profit from the US, reorienting towards international, and being extremely active within fixed income. That's really the danger zone.

JULIE HYMAN: The nonfree-money transition. I like the way that you put that, nonfree money.

Thanks so much, Gabriela. Good to see you. Gabriela Santos is global market strategist at JP Morgan Asset Management. Thank you.