Investing in Steady Stimulus

As per everyone’s expectations, the U.S. Federal Reserve’s Federal Open Market Committee (FOMC) on Wednesday decided to keep all policies unchanged. Its monthly purchases of $45 billion worth of Treasuries and $40 billion worth of agency mortgage-backed securities will continue, as will the ultra low benchmark interest rate currently at 0.25%.

Yet where we did see some change was in parts of the Committee’s careful wording of its current view of the economy and future expectations. These wording changes – slight though they were – did take the markets by surprise, enough to drop the S&P 500 some 13 points or 0.7% within minutes of the FOMC’s press release.

Similar disappointment was seen in the bond market, where the 10-Year Treasury fell some 6 basis points, and also in gold, which fell $17 on the news before stabilizing at just $10 down on the day. About the only thing that rose was the U.S. dollar, which climbed 0.45 of a point.

Why the negative reactions? Does the FOMC’s latest wording indicate that perhaps it is getting close to tapering its monthly purchases after all? If so, where should investors keep their money?

A Few Little Changes

While monetary policy and stimulus measures did not change, expectations seem to have – for both the Federal Reserve and the markets.

The expectation had been that the recent government shutdown and appalling non-farm jobs numbers for August and September – plus Wednesday’s dreadful private jobs number for October – would keep current policies in place. This the markets got.

What the markets did not get from the Fed’s press release, however, was worry. On the contrary, the FOMC seemed quite optimistic on the economy’s recovery and future prospects, as its press release showed in several places:

• “Economic activity has continued to expand at a moderate pace” and “household spending and business fixed investment advanced”.

• “Indicators of labor market conditions have shown some further improvement…The Committee sees the downside risks to the outlook for the economy and the labor market as having diminished, on net, since last fall.” – What? Wait a minute… didn’t the Fed get all those reports showing dismal job creation?

• “The Committee expects that… economic growth will pick up from its recent pace and the unemployment rate will gradually decline.” – Fair enough.

• “The Committee sees the improvement in economic activity and labor market conditions… as consistent with growing underlying strength in the broader economy.” – Now that has to worry the markets that stimulus reduction is still quite close. As far as the Fed is concerned, the economy not only has underlying strength, but such strength is growing.

This could be seen as confusing by the markets. In the face of all the disappointing data over the past three months at least, how can the Fed remain so positive on the economy’s outlook?

The markets wanted to hear that the Fed was fully prepared to keep the money tap running at full blast for a good long time to come. But as Michael Gapen, a senior U.S. economist at Barclays Plc, explained to Bloomberg, “If you were looking for dovish signals, you didn’t get it. They’re keeping all of their options open.”

Might the Fed begin reducing its monthly purchases sooner than anyone expects?

Still Highly Accommodative

Well, the Fed isn’t going that far yet. While the Committee did pepper its statement with plenty of optimism, it still held on to all its prior concerns.

• “The unemployment rate remains elevated.”

• “The recovery in the housing sector slowed somewhat in recent months.”

• “Fiscal policy [ie: the sequester] is restraining economic growth.”

• “The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance.”

• “Taking into account the extent of federal fiscal retrenchment over the past year…” – As it mentioned last time, the Fed is still concerned over Congress’ inability to come to an agreement over the budget.

• “The Committee decided to await more evidence that progress will be sustained before adjusting the pace of its purchases.” – The key word there is “sustained;” they are still waiting for a string of strong months.

• “Until the outlook for the labor market has improved substantially.” – That pretty much sums it all up. Though they see some economic strength (I’m still not sure where they are getting that from), the Fed will continue to be highly accommodative until there is “substantial” improvement.

As Scott Anderson, chief economist at San Franciso’s Bank of the West, summarized to Bloomberg, “Wait-and-see seems to be the prescription for the day.”

“We might not see much [negative] evidence of the government shutdown in the aggregate data,” Dana Saporta, a director of U.S. economics research at Credit Suisse Group, elaborated to Bloomberg. “But we don’t know that, and it will be several weeks before we can analyze the impact of the shutdown and debt-ceiling debate.”

That’s most likely where the FOMC stands. They know they have to take the economy off of stimulus, and they are prepping us for it through their optimism. But they also know that the full impact of the recent government shutdown and the potential impact of another one looming in the near future could upset the still fragile economic, housing, and employment recoveries. So the Fed is sitting squarely on the fence.

How to Invest on the Fed

The markets shouldn’t be so disappointed, really, as nothing has changed. All the Fed did on Wednesday was remind the markets that despite the recent turbulence, tapering is still to be expected.

But so are low interest rates. Even when the monthly bond purchases are terminated, the economy will still have the Fed’s support. Possibly the most reassuring statement the Fed gave the markets on Wednesday was:

“The Committee today reaffirmed its view that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens.”

The key phrase there is “for a considerable time after.” Fear not, therefore, the termination of the monthly purchases. Low interest rates will continue to prop up the equity and housing markets, which should continue to bolster employment.

Investors, then, should prepare for a little jolt to their portfolios when tapering finally does begin – which still looks like March or April. The Fed will likely want to make sure the next budget deadlines in December, January, and February are behind us first.

When stimulus reduction is announced, equities, bonds, and gold should fall a little, while the USD rises. So make sure you are not over-extended on margin, but are ready with some extra cash on hand to buy on the dips. Most equities are still fairly priced even today, with valuations at a comfortable 12 to 15 times earnings. They will be even better bargains on any dips.

Take this Fed statement as your cue: “These actions should maintain downward pressure on longer-term interest rates, support mortgage markets … and help to ensure that inflation, over time, is at the rate most consistent with the Committee’s dual mandate.”

Low Fed benchmark rates will boost stocks and bonds; don’t fear investing in either. Low mortgage rates will help housing; don’t fear the housing sector. And the stoking of inflation to the Fed’s 2% target will help the precious metals; don’t fear gold.

Once the markets get over the initial shock from the start of tapering, look for the bull run to continue across the board for at least another two, possibly three years.

Joseph Cafariello

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