Throughout the year, investors' lack of conviction has resulted in a high level of volatility and se...
Throughout the year, investors' lack of conviction has resulted in a high level of volatility and sector rotation for the US equity market. In this environment, investors may ask "what would it take for the Federal Reserve to actually lower rates and how would this change the market environment?"
First let's consider the Fed's mandate: to achieve stable economic growth with low inflation. We would need to see signs of markedly slower growth in addition to inflationary pressures abating in order for the Fed to ease.
Signs of slowing economic growth are plentiful, including third quarter GDP at 2.7%, decelerating earnings growth, and declining capital expenditures. But what about the inflation side of the equation? Key catalysts needed are lower oil prices, receding wage pressures, lower inflation readings, and continued strength in productivity gains. Until there is visibility that these inflation barometers are benign, it will be difficult for the Federal Reserve to lower interest rates.
One of two scenarios is likely to unfold over the next few months. On the one hand, slower economic growth combines with lower inflation, so the Fed may be likely to ease in order to maintain a soft landing. On the other hand, slower growth is coupled with inflationary pressures in the economy, forcing the Fed to stay on the sidelines.
If the Fed eases, we would expect sectors tied to the domestic economy to outperform the broader market. Historically, economically sensitive sectors such as consumer cyclicals, financial services, and technology are strong performers when the Fed is lowering rates.
In fact, many stocks in these sectors have already priced in a hard landing, making valuations and earnings expectations realistic for the first time in several months. Consumer-related stocks are a good example as retail sales growth has declined from 11% to 8% in the last six months. During this time, estimates have been slashed, valuations have declined, and the sector has severely lagged the broader market.
Under the much less optimistic scenario, we may continue to witness decelerating earnings growth due to higher input costs, including oil and labour. If this were to occur, sectors with relatively stable earnings such as healthcare, defence, and consumer staples will continue to lead the market.
Until we have a clearer sense of the economic outlook, volatility should continue and the current market leaders may continue to outperform.
But if the Fed decides to lower rates in an attempt to avert a hard landing, we may see an important shift in leadership in the US equity markets to sectors such as consumer cyclicals and financial services. We will need to closely watch the upcoming economic data and clues from company earnings announcements for signs of a shift in market leadership.
Susan Everly is fund manager of the Credit Suisse Transatlantic Fund
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