The US Federal Reserve is walking a tightrope—if it acts too quickly it risks hampering growth and market volatility, but if it acts too slowly it risks spiraling price increases. Franklin Templeton Investment Solutions weighs in the Fed’s dilemma. They provide their monetary policy expectations and offer insight into investments they currently favor in their portfolios—and ones they don’t.

A Federal Reserve survey1 last year found that participants cited “persistent inflation; monetary tightening” as the potential shock that would have the biggest negative effect on the US financial system. On November 30, Federal Reserve (Fed) Chair Jerome Powell told Congress that “it’s probably a good time to retire” use of the word “transitory” when describing inflation. He then opened the door to a possible acceleration of monetary policy actions to rein it in. This has investors questioning whether the Fed can effectively manage a “soft landing.”3 Year-to-date (through January 28), global equities have returned -7.9%.3 There is no doubt that we find ourselves in unusual waters. What does the Fed’s course mean for asset allocation?

Key Points

  • Hawkish Fed: The Fed has made it clear—it has turned more hawkish.
  • Great (Fed) Expectations: We expect the Fed to raise interest rates four times in 2022 and to begin reducing its balance sheet. We believe the terminal rate (the natural rate consistent with full employment and stable prices) will be around 2.5%, higher than current market expectations.
  • Macro Comparisons: The current macro environment differs from previous hiking cycles in three ways: interest rates are lower, valuations are richer, and macro fundamentals are more “late-cycle” than usual.
  • Multi-Asset Implications: We became less bullish on equities in December 2021, though we still favor stocks over fixed income and will look to take advantage of market volatility going forward. Within fixed income, we remain short duration although we view the recent back-up in yields as an opportune time to add back some duration exposure. We provide further detail below on our preferences for equity regions, fixed income sectors and currency exposures.