U.S. Retail

Fed Rings Dinner Bell for Equities

The Upshot

1/30/2012

Kristina Hooper breaks down the Fed's decision to keep short-term rates at historical lows and to provide greater visibility on monetary policy, moves likely to beckon stock investors to take on more risk. Plus, what you may have missed in the GDP report.

Investors hungry for yield may have gotten the sign they needed to increase stock portions of their portfolios.

On Jan. 25, after a Federal Open Market Committee meeting, the Federal Reserve embarked on its new policy of greater transparency with regard to its federal funds target rate. Fed Chairman Ben Bernanke surprised the capital markets by announcing that the central bank planned to keep short-term interest rates historically low into late 2014 and possibly beyond.

Some market observers viewed this announcement as a negative indicator, a sign that the economic recovery is tepid or even faltering. Clearly, the Fed is disappointed in the slow recovery–the Leading Economic Indicators Index rose only 0.4% versus expectations of 0.7%—and wants to “juice” economic growth. However, the Fed's interest in speeding the economic recovery also has the consequence of pushing investors out on the risk spectrum.

Come and Get It
Investors should not ignore the historical importance of the Fed’s new transparency policy and its statement last week. After all, investors don’t like uncertainty, particularly after what they’ve been through the past few years. With greater visibility on where interest rates will be for the next several years, investors are likely to be more comfortable moving into riskier assets. If a stock’s required rate of return is made up of two components, the risk premium and the risk-free rate, and if the risk-free rate is virtually guaranteed to remain exceptionally low for the next three-plus years, then arguably it keeps the required rate of return low, all else being equal, and makes stocks more attractive.

Perhaps even more significant is that investors now know their bank accounts and money market funds will continue to produce paltry returns for the foreseeable future–an even greater incentive to move out on the risk curve. The net effect should be an increased investment in riskier assets, particularly dividend-paying stocks because of their significant yield potential.

In addition to the Fed’s announcement, a few key pieces of economic data were released last week. Fourth-quarter GDP grew 2.8% on an annualized basis, below expectations of 3% but at its highest level in about a year and a half. While some viewed the number as disappointing, drilling down into the components of GDP paints a more positive picture: government consumption and gross investment fell 4.6% and federal consumption and investment dropped a whopping 7.3%. Investors should be cheering these numbers given the current government-debt crisis facing the United States.

A Healthy Consumer Appetite
The government clearly seems to be moving in the right direction in terms of reducing spending. Consider that in the 1980s, as the economy recovered from a deep recession, we saw years in which growth in government spending declined, but we never saw what we are seeing now: an actual decrease in government spending.¹ In addition, key components of GDP, such as consumer spending and exports, have risen. Consumer spending was particularly strong, rising to 2% in the fourth quarter from 1.7% in the third quarter, marking its highest quarterly gain in a year. This is an encouraging sign for the economy as consumer spending accounts for roughly 70% of GDP.

The market’s reaction to the Fed’s historic announcement was, not surprisingly, mixed. For the week, the Dow was slightly negative, the S&P 500 was essentially flat and the yield on the 10-year Treasury fell. A bulk of the action was in small-cap and tech stocks with the NASDAQ gaining more than 1% and the Russell 2000 gaining almost 2%. Gold had the strongest reaction to the Fed’s announcement, gaining 4.09%, arguably on expectations that inflation will rise over the longer term if the Fed keeps rates down for such an extended period. Despite geopolitical concerns involving Iran, crude oil stayed under the $100-per-barrel mark.

Expect an exciting week ahead, as investors continue to digest the Fed’s announcement, the European debt crisis generates more media attention and Facebook readies its IPO.

¹Bureau of Economic Analysis

Kristina Hooper is head of portfolio strategies at Allianz Global Investors.

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