December 22, 2024 – Picture this: a central bank meeting room. On one side, we have the hawks, and on the other, the doves. It’s a bit like a financial pet store but with PowerPoint presentations and a serious deliberation regarding monetary policy.
Central bank hawks and doves are metaphors used to describe opposing views on monetary policy, particularly regarding inflation, interest rates, and economic growth.
Hawks are the economic version of gym coaches yelling, “No pain, no gain!” They see inflation as the villain and interest rate hikes as their weapon of justice. If inflation so much as sneezes, the hawks are ready to crank up interest rates faster than the Gingerbread cookies disappear at your firm’s Christmas party. For example, the Fed in the late 1970s and early 1980s, under Chair Paul Volcker, is a classic example of a hawkish central bank. Volcker’s Fed raised rates sharply to combat runaway inflation, even triggering a recession in the process.
Central bank doves, on the other hand, are like those friends who tell you to “chill, everything’s fine.” They prioritize growth and unemployment reduction, treating rate hikes like that last resort no one wants to discuss. Post-2008 financial crisis, Fed Chair Ben Bernanke adopted a dovish stance, cutting rates to near-zero and initiating quantitative easing (colloquially referred to as “printing money”) to stimulate recovery.
Nevertheless, navigating the path of and implementing changes to central bank monetary policy is a group effort. Depending on where we are in the economic cycle, the central bank committee’s management of monetary policy may lean hawkish or dovish. Ultimately, it is a balancing act. Hawks prevent the economy from overheating, while doves ensure it doesn’t grind to a halt. Hawks and doves both care about the economy—they just see different ways to optimize it. The goal of central bankers is to smooth out the business cycle and reduce the boom-bust cycle that can whipsaw investors, workers, businesses, and the economy.
Traditionally, a hawkish Fed is bearish for stocks due to the effect of higher borrowing costs, reduced liquidity, and higher interest rates, which put downward pressure on equity valuations. Conversely, a dovish stance at the central bank is generally bullish for stocks, as lower rates and increased liquidity support equity valuations and stimulate increased risk-taking.
Therefore, it is essential for capital allocators to have a feel for the overall hawkishness or dovishness within a central bank and how it changes over time in reaction to macroeconomic data.
On Wednesday, the Federal Open Market Committee voted 11 to 1 to lower the central bank’s key lending rate by 25bps to between 4.25% and 4.50%. Heading into the event, market participants were pricing in a greater than 90% probability of a 25bps rate cut, and the result ultimately met market expectations.
However, the rate cut was not what grabbed the attention of the market, as that was already baked into market prices. What caught the eye of market participants was the Fed’s forecast of inflation and economic growth, along with the so-called “dot plot” summary of FOMC participants’ forecasts regarding the path of monetary policy via the federal funds rate.
First, the Federal Reserve Board members increased their 2025 real GDP growth forecast from 2.0%, featured in their September projections, to 2.1% currently. Second, their 2025 inflation forecast jumped from 2.2% to 2.5%, signalling an unease with the stubborn cadence of inflation over the past few months. Ultimately, the increased GDP and inflation estimates caused the FOMC to reduce the expected magnitude of future rate cuts.
The Fed went from four expected rate cuts in 2025 to just two, implying a hawkish tilt. Markets reacted swiftly to the central bank’s economic projections, with the S&P 500 dropping -3% for its largest daily decline in months.
Nevertheless, in the context of the central bank’s mandate of stable prices targeting an inflation rate of around 2.0%, its inflation forecast of 2.5% implies a scenario in which no rate cuts in 2025 are necessary. Perhaps the Fed’s dot plot was not hawkish enough.
What does this mean for investors? Stock market risks are to the downside, with 2025 rate cut odds slowing markedly. Presently, market participants estimate the Fed will cut just once next year, with a one-eighth chance of no rate cuts in 2025.
A higher fed funds rate translates to a higher cost of capital for investors and businesses, which leads to lower equity valuations as the cost of money remains elevated. The last time the market was primed for rate cuts that did not materialize due to persistent inflation was in early 2022, which resulted in an equity bear market that year. History doesn’t repeat, but it often rhymes. Heading into 2025, U.S. equity market valuations remain very high, not just compared to their historical average, but also compared to their international market brethren. If the Fed’s hawkish forecast persists, and inflation remains above target leading to fewer (if any) rate cuts in 2025, then stock market investors will face additional risks to the downside.
Investors have much to be concerned about as they review their year-end asset allocation. One way to mitigate downside risks heading into next year is to incorporate hedges, through a portfolio of both long and short positions.
To facilitate hedged equity portfolio ideation, we highlight one top-decile stock expected to outperform and one bottom-decile stock expected to underperform in this month’s AlphaRank Top Stocks.
OUTPERFORM: iA Financial Corp Inc (TSX: IAG) is a prominent Canadian financial services company offering a myriad of insurance and wealth management products. In Q3 2024, iA Financial reported core diluted earnings per common share of $2.93, a 17% growth rate from the same period in 2023. The core return on common shareholders’ equity for the trailing twelve months was 15.3%, meeting the company’s medium-term target of 15%+. The company announced a 10% increase in its quarterly dividend, reflecting confidence in its financial stability and commitment to returning value to shareholders. IAG recently renewed its Normal Course Issuer Bid, authorizing the purchase of up to 5% of its outstanding shares, after reducing its share count by more than -8% over the past year. IAG’s stock price has exhibited strong price momentum in the past 52 weeks, increasing by approximately 46% and outperforming many peers in the financial sector. A portion of this strong share price momentum was due to its significant beat of market expectations with its recent third quarter results. IAG has the 8th highest AlphaRank in the Canadian market, indicating expected outperformance over the near-term. Disclosure: Long IAG in the Accelerate Canadian Long Short Equity Fund (TSX: ATSX).
UNDERPERFORM: Riot Platforms Inc (NASDAQ: RIOT) is a Bitcoin mining company. Its business is capital-intensive, requiring substantial and continuous reinvestment in hardware. It has generated net losses in each of the past 5 years and has relied on dilutive equity issuance to fund its losses. As of November 29, 2024, approximately 14.32% of RIOT’s float was sold short, indicating a significant bearish sentiment among investors, supported by the company’s high valuation and low-quality (lack of) earnings. RIOT has the 9th lowest AlphaRank in the U.S. market, indicating expected underperformance over the near-term.
The AlphaRank Top and Bottom stock portfolios exhibited mixed performance last month:
- In Canada, the top-ranked AlphaRank portfolio of stocks gained 3.6% compared to the benchmark’s 6.7% gain, while the bottom-ranked portfolio of Canadian stocks rallied by 7.2%. The long-short portfolio (top minus bottom ranked stocks) lost -3.6% in a challenging month for short selling. Over the past five years, the top decile AlphaRank portfolio has risen by more than 150%, while the bottom-ranked portfolio has gained less than 30%.
- In the U.S., the top-decile-ranked equities surged by 11.6%, outperforming the S&P 500’s 5.9% gain. Meanwhile, the bottom-ranked stocks jumped 11.2%, leading to a 0.4% gain for the top decile minus the bottom decile long-short portfolio. Over the past five years, the top-ranked U.S. equities have gained approximately 150%, while the bottom-ranked portfolio has risen about 30%.
AlphaRank Top Stocks represents Accelerate’s predictive equity ranking powered by proven drivers of return. Stocks with the highest AlphaRank are expected to outperform, while stocks with the lowest AlphaRank are anticipated to underperform. AlphaRank assigns a numeric value to each security from zero (bottom-ranked) to 100 (top-ranked) based on selected predictive factors. All Canadian and U.S. stocks priced above $1.50 per share and with a market capitalization exceeding $100 million are evaluated. In both the Accelerate Absolute Return Fund (TSX: HDGE) and the Accelerate Canadian Long Short Equity Fund (TSX: ATSX), Accelerate funds may be long many top-ranked stocks and short many bottom-ranked stocks. See AccelerateShares.com for more information.
