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US Economy

Don’t Fight the Fed–Listen to It

By Elliott H. Gue, on Jun. 21, 2013

“Don’t fight the Fed” is one of the oldest saws on Wall Street. For decades, this admonition meant that investors shouldn’t become too bullish when the Federal Reserve hikes interest rates or too negative when the central bank slashes rates.

This caveat still rings true in this era of unconventional monetary policy. Although the US central bank didn’t change the pace of quantitative easing (QE) after the Federal Open Market Committee’s (FOMC) most recent meeting, Chairman Ben Bernanke discussed tapering in a subsequent press conference–sparking a selloff in US equity markets. In particular, this excerpt rattled investors’ nerves:

If the incoming data are broadly consistent with this forecast, the [Federal Open Market] Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year; and if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around midyear.

In this scenario, when asset purchases ultimately come to an end, the unemployment rate would likely be in the vicinity of 7 percent, with solid economic growth supporting further job gains, a substantial improvement from the 8.1 percent unemployment rate that prevailed when the Committee announced this program.

At first blush, this statement confirms the market’s worst fears: The Fed expects to begin tapering its QE efforts at the end of 2013 and cease buying bonds by mid-2014. Bernanke also indicated that the majority of Fed members don’t expect to boost interest rates until 2015–cold comfort for a market concerned that the end of QE will hamper economic growth and the recent bull market. Only two months ago, the consensus expectation called for the Fed to maintain the current pace of bond purchases well into 2014.

Our current outlook calls for the stock market to suffer a least a modest pullback of 5 percent to 10 percent this summer after rallying consistently for much of the year, overcoming the mixed economic news in the US, slowing growth in China and a grinding recession in Europe.

Against this backdrop, the market was long overdue for some profit-taking; the Federal Reserve’s recent disclosures provided a catalyst for investors to book gains. We expect the S&P 500 to drift lower in coming weeks and perhaps bottom out at 1,500 this summer.

Investors should regard this selloff as an outstanding buying opportunity. Although the Fed’s recent statement prepared the market for the eventual end of its QE program, this news hardly comes as a surprise–the central bank couldn’t continue to purchase more $1 trillion worth of bonds annually forever.

Even with the Fed’s planned tapering, monetary policy remains accommodative. The central bank hasn’t announced plans to shrink its balance sheet, and the first rate hike appears to be at least two years away. Meanwhile, 10-year US Treasury notes yield almost 2.6 percent after Bernanke’s recent comments–we expect little upside from current levels.

Investors also shouldn’t forget that the Fed’s decision to transition away from quantitative easing depends on economic data. The central bank’s policy remains flexible, not deterministic.

At the most recent FOMC meeting, the central bank left its projections for US economic growth in 2013, 2014 and 2015 largely unchanged. The regulator lowered its projection for 2013 economic growth to between 2.3 and 2.6 percent from between 2.3 and 2.8 percent. The Fed now forecasts economic growth of 3 percent to 3.5 percent in 2014, a slight improvement from 2.9 percent to 3.4 percent.

In contrast to these modest tweaks, the Fed now expects the unemployment rate to improve to between 7.2 and 7.3 percent, an upgrade from the prior range of 7.3 percent to 7.5 percent. The central bank’s latest estimates call for this figure to drop to between 6.5 and 6.8 percent in 2014, compared to the previous forecast of 6.7 percent to 7.0 percent.

These adjustments to the Fed’s outlook suggest that the central bank expects the percentage of the population that’s considered part of the labor force to continue to shrink–a reflection of an aging population and the subpar economic recovery after the Great Recession. In a robust labor market, rising wages would fuel an increase in the labor participation rate; the opportunity to collect a solid paycheck would draw more people into the workforce.

Source: Bloomberg

We regard the Fed’s latest economic forecasts as overly optimistic. The US economy appears to have entered its seasonal soft patch, which should restrict growth to less than 2 percent in the second quarter. That being said, economic activity should improve gradually in the back half of the year.

Investors should also keep an eye on international developments; in aggregate, S&P 500 members generate more than 40 percent of their earnings outside the US. Of particular note, HSBC (LSE: HSBA, NYSE: HBC) and Markit’s preliminary reading of 48.3 for the Chinese Purchasing Managers Index suggests a sharp slowdown in the nation’s manufacturing activity. And although we expect the EU economy to stabilize in the back half of the year, the region remains in recession.

Source: Bloomberg

If the US economy continues to grow at a lackluster pace, expect the Federal Reserve to rethink the timetable for phasing out its bond purchases.

In the event that the US economy lives up to the Fed’s optimistic projections, the salutary effects of this economic growth should outweigh headwinds related to higher borrowing costs–an encouraging scenario for the stock market.

The Bottom Line: Although the Fed’s plan to phase out its QE program should weigh on the stock market in coming weeks, investors should regard this correction as a buying opportunity. In the inaugural issue of Capitalist Times Premium, Roger Conrad and I highlight our favorite picks and sectors for both growth and income investors. 

Elliott H. Gue is founder and chief analyst of Capitalist Times Premium and Energy & Income Advisor.

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