Last night’s policy statement showed that the Federal Reserve (Fed) was more optimistic about the economy than the previous month. In the Fed’s released statement and economic projection, economic downside risk has diminished. What remains unchanged is that bond purchase policy continues to be determined by incoming economic and financial information.
Looking at the Fed’s economic projections, it is clear that they are more comfortable that growth may surprise on the upside (Figure 1). Even the unemployment rate has been brought down, thus increasing the odds of monetary tightening (defined as raising interest rates) in 2014 or 2015. The Federal Reserve has also clarified that a tapering (reduction) or even cessation of the bond buying program would still centre around the unemployment rate at around 7% (currently at 7.6%).
Figure 1: Economic projections of Federal Reserve Board, June 2013.
The implications for markets are already apparent. Volatility is higher as policy change is being discounted by markets. Fixed income, the darling of investors the past four years, has started to lose its allure as markets begin pricing in higher rates. The US dollar has strengthened, especially against emerging market currencies, as future supply is being curtailed.
One potential beneficiary of the policy change is the equity sector. After all, monetary normalisation is the result of the US economy being on a stronger footing. This is positive for equities as companies would be expected to post better earnings in a healthier economy.
So far, the signals from markets confirms this scenario. Domestic cyclical sectors like consumer discretionary and financials continue to outperform the market, even during the current market correction (Figure 2). With defensive sectors like staples and utilities underperforming and falling on an absolute level, it is clear that investors are rotating out of these sectors into stocks that will benefit more from economic growth.
Image courtesy of Stockcharts.com
Figure 2: Relative performance of consumer discretionary
Our view remains unchanged despite the odds of higher interest rates coming up on the horizon. Equities, and especially US equities, are likely to head higher going forward, simply on the basis that the economy (and hence profits) are improving.
We had already executed the switches as per our earlier recommendation and our portfolios are now poised to take advantage of any upswing in equities.
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