There are a lot of unanswered question regarding what’s next for the Federal Reserve. Who will become the next Fed Chairman when Ben Bernanke’s term end in January? When will the Fed start raising interest rates? When and how will the Fed begin to taper its monthly purchases of $US85 billionworth of Treasury and mortgage bonds?
The answers to these questions could have varying implications for the economy.
But Wall Street’s top stock market strategists think that all of this uncertainty surrounding the Fed is just not a big deal.
“The US equity market has been insensitive to yield curve shifts since mid-July, suggesting it has reached an equilibrium around anticipated tapering of QE,” said Morgan Stanley’s Adam Parker. The yield curve shift he’s refering to is the difference between long-term interest rates and short-term interest rates. Short-term interest rates have remained near-zero while long-term interest rates have been climbing for much of this year.
Here’s JP Morgan’s Tom Lee regarding the next Fed Chair:
…Investors see negative catalysts in coming weeks. The perspectives varied on which was seen as the most important, but the nomination of a new Fed Chairman was most cited. Since 1950, there have only been six Fed Chairman — longest tenure, William Martin, Jr. 1951-1970; shortest, G. William Miller, 1 year 5 months from 1978-1979. Most investors are familiar with Janet Yellen (the current Vice Chairwoman of the Fed) as a potential candidate and seem less comfortable with Larry Summers (most likely because he surfaced more recently as a catalyst). But the lack of familiarity does not mean this is a negative for markets longer term — it simply means uncertainty short term. And this is why we are less troubled by some of these noted issues — they may be holding back decision making (by investors) but unless these change the fundamental trajectory of GDP growth, it will likely not have a lingering impact in our view.
Goldman Sachs’ David Kostin acknowledges there are definitely risks to the downside in the near term. But he also notes there is plenty of good news to offset all of this talk about the Fed.
Three important upcoming policy events for equities
The FOMC QE tapering decision, nomination of an FOMC chair, and US debt limit expansion are known risks. We expect a “dovish taper” of $US10 bn in Treasury buying alongside strengthened forward guidance. The debt limit debate should be less disruptive than 2011 but a potential tail event.
Good news on growth should overcome policy risk
We forecast a steady build to 3%+ real GDP growth from 2014 — 2016. A pick-up in private consumption and less fiscal drag drive stronger US growth. We also expect Fed commentary to support easy policy and mute any tightening in financial conditions from the expected QE taper.
The waning fiscal drag is a story that doesn’t seem to get much attention, especially considering the fact that the U.S. economy has managed to grow respectably in the face of tax hikes and sequestration.
The headwind from fiscal drag should also moderate from 1.7% of GDP to about 0.5% of GDP as we move through 2014. That improvement is driven by less impact from taxes and sequestration in 2014 vs. 2013. As a result, we expect federal spending growth to improve to -5.2% in 2014 from -5.7% in 2013 and ease to just -2.5% in 2015. Notably, we expect state and municipal spending to be positive the next three years for the first time since 2009. Federal, state and local government spending accounts for 19% of GDP, making it an important, if perhaps less exciting, element of our growth outlook.
It seems like a sure thing that the economy should pick up when you consider the chart above. But if the economy doesn’t deliver, we may be faced with a spike in volatility. Here’s Bank of America Merrill Lynch’s Michael Hartnett:
Significant monetary stimulus, the end of fiscal austerity, a booming housing market, a cheap dollar, record corporate cash balances…if the US economy does not significantly accelerate in coming quarters, it never will. We assume it will, and favour assets (e.g. equities), sectors (e.g. banks) and markets (e.g. Europe) that have lagged in the “High Liquidity-Low Growth” world of recent years.
Asset price will not do as well in the next 5 years, no matter what the “nouveau bulls” say. Central banks will be less generous, corporations less selfish. And when excess liquidity is removed it will get “CRASHy”. The dollar and (temporarily) volatility will be the last assets to surge as Deleveraging ends and an era of Normalization begins.
The Fed’s FOMC meeting will conclude at 2:00 p.m. ET on Wednesday.
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