Each week, we tap the insight of Sam Stovall, Chief Equity Strategist for S&P Capital IQ, for his perspective on the current market.
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EQ: For a while now, investors have had somewhat of a seesaw dynamic with the Fed and the eventual tapering of the bond purchasing program. As we enter the final months of 2013, how likely do you think that the Fed will begin the slowing of its purchases?
Stovall: We’re pretty confident that the Fed will be slowing its purchases sometime this year, but I think based on the market’s movement after the release of the July FOMC minutes, all the Fed did was add to the confusion as to whether the tapering will start in September or be delayed until December.
Too many people were voting for the delay, but there were an awful lot that were voting for immediate action, which basically offered no conclusion in our opinion.
EQ: Since hitting its all-time high in early August, the S&P 500 has pulled back just under 4 percent while bond yields have spiked. Is the market starting to price in the Fed’s eventual move?
Stovall: I believe it certainly is because they know it’s just a matter of time. They’re just trying to figure out what that time is. So it’s not a matter of if they’re going to do it, it’s actually when they’re going to do it. I think the Fed, in a sense, raised some trial balloons in their May meeting, indicating that they were going to be doing it relatively soon. So the market responded negatively when it reacted to the prospect of higher rates, and tended to recover but only to be beaten down again once the Fed then came out to say, “Well wait a minute, we didn’t say it was going to happen. It is going to be data-dependent.” Wall Street doesn’t like uncertainty, and all that we got on Wednesday from the FOMC minutes was more uncertainty.
EQ: If and when the move officially happens, could the reaction be less dramatic than most people have feared because of this gradual pricing in?
Stovall: Yes, I think there’s a possibility of that because investors have had so much time to prepare for the eventual announcement of the tapering that it will end up being a yawn event when it actually occurs. We might find that investors sell on the rumor, but buy on the fact.
EQ: In this week’s Sector Watch report, you examined the current levels of the 10-year Treasury note, and the historical spread based on where the nominal GDP and CPI levels are. Does the yield still have some room left grow despite its recent spike?
Stovall: Yes, I believe it does. What my study showed was that historically, the average difference between nominal GDP—or GDP in which inflation has not been stripped out—and the yield on the 10-year note was about 50 basis points. So if nominal GDP, when we get our second quarter revision, moves up to about 3.5 percent as we expect, then a normal 10-year note yield could be 50 basis points lower, which equates to about 3 percent.
If, however, you prefer to gauge the 10-year note based on inflation, then prepare for a higher 10-year note. The average spread between the monthly yield on the 10-year note and the monthly reading for headline CPI going back over the past 60 plus years was about 2.2 percent. Inflation today is at 2 percent, so if you factor in the spread, that would give us 4.2 percent for the 10-year note yield, and that could be the high water mark for where it ends up.
EQ: Are there any areas in the equities market that you would look at to reduce exposure to rate sensitivity?
Stovall: We have had underweight recommendations on the two highest-yielding sectors in the S&P 500, which are Telecom Services and Utilities. If we felt that the Fed Funds rate is going to be rising aggressively, then I would say that we might want to look at other areas in which to reduce our exposure.
Back in 1994 when the Fed raised rates from 3 percent to 6 percent and the yield on the 10-year note went from 5.75 percent to 7.75 percent, what we found that Utilities were the worst-performing sector, and Industrials and Consumer Discretionary were slight underperformers to the overall market. We currently have an overweight recommendation on Consumer Discretionary so we would certainly have to reevaluate that recommended weighting if we felt that the Fed would be more aggressive on its rate policy program.
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