Outcome of Fed meet may trigger stock rotation

NEW YORK: United States equity investors could rotate out of high-yielding sectors and into stocks of banks, which would benefit from the next leg up in interest rates, after the Federal Reserve’s (Fed) policy-setting meeting wraps up on Wednesday.

If the Fed were to give a nod to rising inflation or focus its trimmed-down bond buying on longer-dated bonds in winding down its balance sheet, there could be a shift around of preferred sectors, said investors.

“In the short run financials will benefit,” said Chad Morganlander, portfolio manager at Washington Crossing Advisors, if the Fed action pushes long-term rates higher relative to shortterm rates.

This week’s meeting is not expected to result in an interest rate increase, but investors will focus on how Fed chair Janet Yellen characterises recent inflation readings for clues to the likelihood of a hike in December, as well as on how the US central bank will begin to wind down its US$4.5 trillion (RM18.87 trillion) balance sheet.

Inflation has been persistently low but Yellen could dismiss this as transitory and point to recent stronger-than-expected data on consumer prices.

Any heightened expectations of a rate increase could fuel a rotation and “will certainly change leadership” among market sectors, favouring financials, industrials and materials, according to Jim Paulsen, chief investment strategist at The Leuthold Group in Minneapolis.

“It would put pressure on utilities and telecoms” as well as on companies that consistently increased quarterly paybacks to shareholders, he said.

Investors typically sell shares of utilities and telecoms as well as high dividend payers when interest rates rise, partly because they lose their appeal as bond proxies since investors can expect similar returns in bonds, which are seen as safer assets.

So far this year, the S&P 500 banking index is up less than four per cent, underperforming the 9.2 per cent gain in the S&P 500 dividend aristocrats index. S&P 500 utilities are up 12 per cent.

While the Fed’s expected announcement of the trimming of its balance sheet has been well telegraphed, investors will look for any Fed reveal on its preference for shorter- or longer-dated bonds when it reinvests a portion of its maturing assets.

If the focus was on the repurchase of short-term assets, that would likely push the long end of the yield curve higher, driving investors’ attention also to shares of banks, which would theoretically make more money with the help of higher net interest margins, said Morganlander.

However, long-term yields in the US are not immune to the effect of low-yielding bonds in other developed countries like Germany and Japan.

“The general tendency based on global rates will continue to pressure the yield curve,” said Morganlander.

While the Fed’s quantitative easing programme was a pillar of the US stock market’s march from then-12-year lows on the S&P 500 in 2009 to current recordhigh levels, winding it down is not expected to produce a major market reaction on the downside.

The Fed is expected to initially trim no more than US$10 billion per month from its US$4.5 trillion portfolio, with the cap rising each quarter for a year until it hits US$50 billion monthly.

The slow and steady move would not turn the US central bank into a seller. The Fed would allow assets to mature without reinvesting the totality of those maturing assets, which would trim some US$300 billion from the Fed’s portfolio after the first year according to analysts.

“It’s going to be run-off, not outright sales, so that in and of itself is a very gradual process,” said Art Hogan, chief market strategist at Wunderlich Securities, here. Reuters