Indeed, quantitative easing acts through two channels: first, the portfolio balance effect, whereby long-term asset purchases lead to a decrease in the term premium on bond yields. And second, the expectation channel, which flattens the yield curve through the pricing of lower policy rates in the future.
The Federal Open Market Committee statement in June highlighted that downside risks to the outlook had diminished, removing one of the elements that justified QE3.
Meanwhile, chairman Ben Bernanke made it clear for the first time that the Fed intends to lower the amount of asset purchases by year-end, if the economy behaves as forecast. These are clear signals that markets should prepare for a gradual policy tightening.
Markets had started to anticipate some change in policy stance following Bernanke’s testimony to Congress on 22 May. Since then, yields have increased sharply, endangering the US ‘tepid recovery’.
According to our macro scenario, the recent steepening of the yield curve is over-played. Regardless, the fact remains that financial conditions have started to tighten.
And now for the good news
Even if, in the short-term, equity markets react negatively to a reduction in the Fed’s buying programme, it must be seen as a positive signal based on increasing confidence in the economy. Three factors underpin the Fed’s positive view on the economic outlook.
First, the economy has been quite resilient to fiscal tightening, with the labour market barely noticing the sharp increase in taxes that occurred at the start of the year.
Second, the housing market recovery has been gaining momentum, with housing starts reaching one million units in March, and home prices rebounding by close to 10% from recent lows. The Fed believes that the contribution of the housing sector to the economy will increase, both through higher employment and wealth effects.
Finally, financial conditions continued to improve, as equity markets surged and banks continued to loosen credit conditions.
Picking up speed
Non-residential investments are expected to be a key support for domestic economic activity and are a key assumption in our central scenario.
Even if public consumption has been revised downward, and might be a small drag for the economy in the coming quarters, the slowdown observed during the second quarter of this year is now over, and the Institute for Supply Management indices have given clearer signs of a pick-up in economic activity.
Most components of the index have moved in a positive direction. Therefore, we expect a progressive improvement in US GDP for the coming quarters.
We anticipate the reduction of the Fed’s buying programme, so-called ‘tapering’, to be enacted in December. Further, we think that government bond purchases will be the first to be reduced, while the mortgage side will be kept stable.
During this period, we should see efforts from the Federal Reserve’s chairman to calm investors’ nerves.
Ahead of the pack
Looking at the overall picture in relation to equities, the US market seems to be the most promising in the advanced economies: an above-average growth outlook, an uncompromising Fed commitment to support the economy, huge diversity of stock/theme opportunities, and unparalleled liquidity.
In the medium term, the shale oil and gas boom will also have a positive impact on both the US economy – owing to lower energy prices – and the US trade balance sheet.
Furthermore, we like the relatively defensive character of the US stock market, and the auspicious dollar for euro-based investors.
One should nevertheless avoid being greedy, given that several short-term uncertainties still exist (beyond Syria) – such as the previously-raised question as to whether the Fed can limit volatility during QE tapering, the 2014 budget, the debt-ceiling and the nomination of a new Fed chairman.
Following Bernanke’s testimony to Congress in May, it is clear that stock markets are shifting from a liquidity-driven world to a macro-driven environment. In this environment, we favour cyclical stocks.
We prefer pro-cyclical industries like semiconductors, capital goods and mining, which should benefit from a gradual improvement in growth conditions.
In semiconductors and capital goods, the recent improvement in leading indicators, companies’ restocking and satisfactory earnings reports have been encouraging. The mining sector is attractive (value stocks), even more so since the beginning of this year.
Materials in general remain among our preferred cyclical sectors, given that growth expectations and valuations are relatively low compared with other cyclical areas.
The news flow coming from China (GDP) has been disappointing, but most bad news has been priced in. In the short-term, the sector is oversold and we expect a rebound.
We also maintain a positive stance on US oil services. Year-to-date, this industry has outperformed, thanks to solid order books, strong exploration drilling, and attractive valuations. The rise in oil prices has been an additional tailwind for the industry. We are, however, considering taking profits after this strong performance.
In anticipation of a gradual economic recovery and ongoing appetite for risky assets, we recently upgraded the US semi-conductor industry from neutral to positive, owing to strong smartphone and tablet demand, rising orders, restocking and a solid expected second-quarter earnings outlook.
Here might be a good entry point after the recent sell-off.
On the defensive
Consequently, we are generally cautious on defensive sectors. At this stage, only healthcare is graded positive, as it remains our favourite defensive sector thanks to solid fundamentals (new medicaments in the pipeline, strong balance sheets, cash flow generation).
Close monitoring is necessary and we are prepared to take profits and downgrade the sector to neutral from positive, while rotating into a cyclical sector – tech, for instance. Such a rotation is premature, however, given downside risks in the short-term.
Overall, the US equity market, backed by sustainable economic growth figures, leaves us upbeat. Even if the Fed does decide to start to slow QE in the coming quarters, it seems stable enough – more so than any other equity market – to adapt from a liquidity-driven to a macro-driven environment.
Thomas Langefeld and Béatrice Guinet are members of the advisory desk at BNP Paribas Wealth Management in Frankfurt, Germany. Head-quartered in Paris, BNP Paribas Wealth Management is present in 30 countries and has 6,000 employees worldwide. At the end of June, the company managed assets of €272bn.