The U.S. Federal Reserve’s decision last month to delay tapering — after months of intimating that it was preparing to scale back its $85 billion-a-month bond-purchase program — caught many investors off guard. The postponement has its upside and its down; at the moment, however, confusion seems to be the dominant reaction to the news. Institutional Investor asked directors of U.S. equity sell-side research to help put the central bank’s strategy in perspective and describe what they think the future holds.
Institutional Investor: The Fed’s decision surprised many market participants. What questions and concerns have clients raised, and how have you responded?
Noelle Grainger, J.P. Morgan: Our chief economist, Bruce Kasman, has advised investors that “discretion is the better part of guidance.” The Fed has strengthened its growth bias, moving to less rule-based, more discretionary forward guidance. Rising rates have led to increased [Federal Open Market Committee] skittishness about the health of the economy. If the economy picks up steam — as we still expect it to going into year-end — the Fed’s purchase plan should be completed by mid-2014, although the message of heightened sensitivity to growth risks could have more of a lasting impact on policy actions.
Steven Pollard, Deutsche Bank Securities: The basic questions being asked are whether rates will stay lower for longer, and what to do with client portfolios that have been set up to take advantage of a rising-interest-rate environment. We are telling our clients that the taper will happen, it was just postponed. This is a risk-management decision by the Fed but not a change in policy. We think clients should use this period to position their sector allocations toward those that offer the most beta to rising rates.
Jonathan Rosenzweig, Citi: Clients were surprised by the Fed’s decision to postpone tapering, as can be seen from the equity and bond markets’ reactions. We have responded by explaining why we believe the Fed made this decision and why we think, despite the Fed’s cautious stance, that the recovery is still on a sustainable trajectory.
Brett Hodess, Bank of America Merrill Lynch: We were not surprised by the Fed’s decision to delay tapering. In fact, our chief economist, Ethan Harris, was one of the lone voices saying the Fed would not taper at this time. We felt the data had not improved enough to warrant tapering and, with budget battles brewing, September was an awkward month for the Fed to move.
The Fed indicated that the U.S. economic recovery is still too fragile to stand on its own. Do you agree with this view?
Rosenzweig: Our analysts think the Fed is being very cautious but understandably so given the limitations of guidance as a policy tool in the absence of asset purchases to manage longer-maturity interest rates. Citi’s macro strategists believe that some positive signs include the best hiring intentions in years from the National Federation of Independent Business and ManpowerGroup surveys. Eased credit conditions usually lead capital expenditure and head count investment by nine months, and this should start now. Less commodities price pressure and better home prices help consumers, while higher stock prices benefit consumer spending for wealthier people, who have a disproportionate effect on [real gross domestic product growth]. Signs of caution include mortgage activity slipping, core retail activity growth slowing and consumer confidence data slipping. Emerging economies with current-account deficits are hurting, which could limit U.S. exports.
Grainger: Our chief U.S. economist, Michael Feroli, believes that the FOMC was more nervous about the resilience of the economy than it had conveyed in public statements. Now that the Fed’s decision to postpone tapering has been absorbed by the markets, the question becomes, When will the first tapering take place? That depends less on how markets react and more on how the data prints in coming weeks.
Hodess: With the fiscal shock of sequestration and higher taxes still playing out, we believe the economy needs the Fed’s full support. However, as the fiscal shock fades, the Fed should be able to gradually move to the sidelines.
What changes, if any, has the Fed’s decision prompted your team to make to its outlook for the rest of the year?
Grainger: Thomas Lee, our chief equity strategist, has been constructive on equities consistently for the past four years, and while he has not made any changes to his views on the heels of the Fed decision, he sees the Fed’s actions as positive for the U.S. equity market for the following reasons. One, interest rate expectations are lower, leading to lower costs for consumers and corporates. Two, the Fed has provided some insurance against risk as we move toward year-end. Three, the right groups are rallying, with cyclicals leading — not just ‘bond proxies.’ Finally, the rally has shown that investors are underweight risk, including for equities. We had been advocating a cyclical tilt moving into year-end, based on expectations of improving economic momentum in Europe, pent-up demand in the U.S. and stabilizing conditions in China. We remain constructive, with a year-end target of 1,775 for the S&P 500.
Hodess: From a macro perspective we believe the delay in tapering underscores that the Fed wants to exit slowly and without hurting the stock market. With persistent low inflation we expect that the Fed will only exit in the context of solid growth, rising employment and the attendant rise in earnings and investor confidence. Tapering should be good news for stocks but does benefit some sectors more than others. Our recommended rotation out of higher-yield (utilities and telecommunications), early-cycle (retailers) and consumer-spending stocks into corporate-spending (technology and industrial) stocks that benefit from slowly rising rates is bolstered by the Fed’s decision. The shift to these industries echoes the work by our rates team in forecasting slowly rising long rates but a cap on short rates until 2015.
Rosenzweig: The decision did not prompt us to make any changes to our fundamental equity research plans for the remainder of the year. However, the macro team did move its expectation for tapering from September to December. They also raised the probability of further extension of quantitative easing relative to their base case of tapering.
Pollard: We have revised our view of Fed policy to a taper now likely to occur in December. The no-taper result gave the markets a lift and bolsters our view that the economy will be strengthening over the balance of 2013 and into 2014 — barring a significant mishap around impending fiscal deadlines.
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