Before The Bell
The U.S. stock market, which fell sharply to start the week on concerns about China’s debt-ridden property market and a possible default by one of the country’s largest developers, has staged a partial rally the last two trading days, and the futures, which held steady after initial weekly jobless claims came in at 351,000, well above the consensus expectation of 320,000, are indicating that the buying will resume when the market opens. The recovery from Monday’s selloff initially was the product of some bargain hunting, but the rally picked up steam yesterday in another “don’t fight the Fed” moment for the market.
The Federal Reserve’s decision to hold short-term interest rates steady at near-zero percent and make no immediate changes to its monthly $120 billion bond-buying program was music to the ears of investors who were recently unnerved by a host of factors, including the aforementioned debt worries for China’s highly leveraged property market and whether China-based Evergrande’s crisis would be a global contagion; the looming debt-ceiling battle on Capitol Hill and the possibility of a government shutdown if a deal can’t be brokered among lawmakers; and slowing global growth, particularly in China, the world’s second-largest economy. Although the central bank left the possibility of beginning a tapering of asset purchases by the year’s end—depending on if enough economic progress is seen—the Fed was still viewed as quite dovish, and that gave a boost to stocks yesterday. It is worth noting that the Fed’s Financial Stability report is due in late November and if that were to show an improvement in the strength of the U.S. financial system, it may provide the central bank with an opportunity to announce a reduction in its monthly asset purchases at its November FOMC meeting without causing a taper tantrum on Wall Street.
In addition to the Federal Reserve’s decision, it updated its economic projections for 2021 and 2022. The central bank raised its inflation expectation for this year from 3.4% to 4.2%. However, the upward revision to the inflation forecast did not rattle the market, as the estimate for next year was still in the 2.0% vicinity, which is right around the Fed’s target range, and the central bank maintained its stance that the price increases were mostly transitory in nature. That said, the inflation-trade stocks were helped yesterday by the upward revision to 2021 pricing projections. Meantime, the lead bank lowered its 2021 GDP growth estimate from 7.0% to 5.9%, but kept its 2022 forecast calling for growth of slightly above 3.0% in place. The slower growth projections might have worked in favor of equities yesterday, as it had investors thinking that the Fed would not rip the monetary support band-aid off too quickly.
Indeed, the one thing that has historically been a big problem for bull markets is when the central bank abruptly changes to a more-hawkish stance on monetary policy. Although Fed Chairman Powell said in his news conference yesterday that he would like to see the asset purchases end by mid-2022, that timeline would require the U.S. economy continuing to make progress. Likewise, only a few more Fed leaders (nine versus seven in July) are expecting a rate hike in 2022 and that would likely come toward the end of the year. The conclusion that investors drew from the Fed’s statement and commentary is that our central bank will remain highly accommodative well into 2022. And even if the Fed were to begin reducing its monthly bond-buying program by $15 billion in December and end it by Powell’s next June goal, the central bank would still pump an additional $600 billion into the financial system over that time frame.
So what is an investor to do in an environment where the Federal Reserve is still highly accommodative, but the market is facing a “wall of worry,” including the looming debt-limit showdown on Capitol Hill? We recommend keeping a significant portion of one’s portfolio in equities, especially as the central bank’s loose monetary policies have resulted in few attractive investment alternatives to stocks.
In general, we would look at the high-quality stocks, particularly those ranked 1 (Highest) or 2 (Above Average) for Safety by Value Line, as that group has historically fared better than the broader market during period of heightened volatility. Investments in quality companies with healthy balance sheets and strong cash flows may be the best near-term route in this choppy market. These companies also are likely to perform better than their smaller-sized brethren when economic growth is slowing. The flattening of the yield curve after yesterday’s Fed statement would suggest that the bond market thinks we are headed toward a period of slower economic growth. This may work in favor of the mega-cap technology names, including the FAANG stocks.
Likewise, the companies that are also best equipped to handle the supply-chain challenges and have the ability to pass the resultant elevated operating costs onto the consumer, like apparel and shoe giant NIKE (NKE), may fare the best in the current environment. Conversely, the food processing group may have a harder time dealing with the supply-chain disruptions. These concerns were noted by J.M. Smucker (SJM) during its last earnings conference call.
– William G. Ferguson
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.
