The Fed 'doesn't have very much room to maneuver,' strategist explains

Emily Roland, Co-Chief Investment Strategist at John Hancock Investment Management, joins Yahoo Finance Live to discuss the impact that Omicron has on the markets and give a stock market outlook for 2022.

Video transcript

BRIAN SOZZI: The latest wild swings in the markets have sent many strategists and investment managers back to the drawing board on their 2022 outlooks and attack plans. Let's see what Emily Roland is up to right now. She is the co-chief investment strategist at John Hancock Investment Management. Emily, always nice to see you here. So market's back in rally mode, what looks to be day two of that rally. My question to you, is this a sucker's rally or the start of the long-awaited Santa Claus rally?

EMILY ROLAND: You know, we do think that there is fundamental support there for markets to continue to move higher here. Obviously we had a couple of things spook us over the last week or so, the emergence of the omicron variant as well as this pivot from the Fed, potentially seeing them accelerating their tapering of asset purchases here. But the bottom line is that the economy is strong.

We look at things like the leading economic indicators, which is a great way to conduct cycle analysis, and right now that data is coming in at 9.3% year over year. That's awesome. We look at things like services PMIs last week in the US, which came in at an all-time high.

So until it looks like we're inching closer to a recession here, which we're nowhere near at this point, it's hard for us to get too defensive. So we continue to embrace equities, we like the US the most, that's where we're seeing the best relative economic growth, that's where we're seeing the best relative earnings growth. And again, the other element here is that there is a ton of cash on the sidelines that's looking to get put to work.

So sentiment is not overly optimistic right now. We saw $200 billion go into money market funds so far this year. We're seeing record cash balances. So that to us is a sign that there's more cash ready to be deployed and that this market can continue to run.

BRIAN CHEUNG: Emily, Brian Cheung here. Now one of the kind of themes that you have for 2022 is the possibility of a Fed making a policy mistake. What is a policy mistake based off of your definition? What do you have as their expectation for how many Fed interest rate hikes we might see? Because Fed funds futures contracts markets have been moving quite a lot over the last week or so. And in fact, it seems like a lot of people are pricing in the possibility of three rate hikes next year.

EMILY ROLAND: Yeah, we're actually seeing the two-year Treasury even moving a little bit higher this morning in terms of the yield there. Our definition of a Fed policy mistake is that they move too fast. We all know that bull markets don't die of old age, they get killed by the Fed every single time. And right now we think that the markets are pricing in an overly optimistic, if you will, scenario in terms of Fed rate hike.

What we look at right now is the Treasury yield curve. And it's actually, really flattened significantly over the last couple of weeks is that the yield on the two-year Treasury, which most closely reflects Fed policy, pricing in those more aggressive rate hikes, we think that's based on that better economic data that we're seeing here in Q4 in the US.

Meanwhile, the 10-year Treasury is pricing in, in our view, a slower economic growth trajectory into next year, pricing in inflation expectations that are actually starting to come down over the long term. So that's resulted in this flattening act. And now at 80 basis points on the yield curve, the Fed really doesn't have very much room to maneuver here without risking inverting the yield curve, which as we all know, is the number one harbinger of a recession.

So The Fed's got to have an eye on this. And they are going to be, we think, pretty cautious if we continue to see this flattening action into next year.

JULIE HYMAN: Hey, Emily, just to make sure I understand this. So if you're just looking at the economic backdrop, the Fed's not a risk, right? Because if the economy is growing robustly, if inflation is indeed an issue as it seems to be currently, if we're reaching full employment, that's a scenario in which the Fed should indeed tighten, right? That's what it's supposed to do. But what you're saying is because the market has not priced it in appropriately, the bond market specifically, that's why it would be a problem?

EMILY ROLAND: Well look, it's a great question Julie, and a lot can happen in terms of the shape of the yield curve. If we do start to hear language out of the Fed that they start to kind of pull back on this idea of tapering early, they start to pull back on this idea of aggressively raising rates if inflationary pressures subside, which is our base case, potentially the short end of the curve starts to come down and the yield curve can start to widen again.

The bottom line though is what is the catalyst for the yield on the 10-year Treasury to move significantly higher for here? You know, maybe it's higher commodity prices. We would fade that into next year. And into next year, by the way, we don't think economic growth is going to fall off a cliff, you're just not going to see that same fiscal bazooka that we saw in 2021 in 2022. We did $10 trillion of stimulus across both fiscal and the Fed doubling the size of their balance sheet this year.

We're just not going to see that same amount of stimulus into 2022. So we want to think about this mid-cycle playbook, right? It happens every time after that initial sort of early cycle risk on rally in the markets. Things tend to get a little bit more difficult in years two, three of that recovery, and that's really what we're positioning for heading into next year. It's owning quality stocks, it's favoring the US, and it's thinking really carefully about where you want to be invested in fixed income. We like corporate bonds and the double B space with a little bit of high yield in there and the upper rungs of the credit spectrum.

BRIAN CHEUNG: So I want to expand a bit on credit because this is kind of a theme that we've seen very much for the entirety of 2021, which is it's a great environment, even if you're perhaps a junk-rated issuer, to kind of build up your credit here and try to take advantage of low interest rates. But we're starting to see a little bit of that shift. And in fact, it's interesting to see a lot of supply for corporate debt kind of get pulled forward because of anticipation for rate hikes next year.

Do you feel like high yield or investment grade is actually an attractive opportunity right now or are there a lot of traps because of simply the liquidity pull forward that could signal some concern for 2022?

EMILY ROLAND: We think you have to be more careful within the high yield space going into next year. If you look at the triple B part of the high yield bond market, it has performed exceptionally well. In fact, the more risk that you've taken in bonds this year, the better you've done with the exception of tips, which is one of the best performing asset classes for its own idiosyncratic reasons.

But we would pull back on that. We think it's going to be hard to squeeze more out of the lower rungs of the high yield bond market, and we would really think about those double Bs, those fallen angels, that continue to have the ability to be upgraded as this economic cycle unfolds. Again, we're nowhere near recession, so we think high yield spreads can stay contained. We think you can continue to see out-performance from that double B space. And we would pair that with triple B corporate bonds. We think that there's a nice starting yield potential there.

We want to be very, very careful here about having a combination of higher quality bonds for this mid-cycle period and combining that with credit as we enter this more challenging period. Where we don't want to be is short duration, ultra short duration. There's simply no yield potential and you're going to get hit right off the bat and reduction in your purchasing power if you're owning the very highest quality bonds into next year.

BRIAN SOZZI: Emily Roland, co-chief investment strategist at John Hancock Investment Management. Good to see you, and good to see you not on jobs day. Good to see you. We'll talk to you soon.