Investors attempted to divine the future of U.S. monetary policy following this week’s Fed meeting and watched with wide eyes as Alibaba became the largest ever U.S. IPO. For investment bankers underwriting shares of Alibaba, the timing of this $22 billion offering couldn’t have been better as U.S. stocks remain well bid amidst record levels of corporate profits and low inflation. Do record levels for U.S. stock prices and a feeding frenzy for the newly traded shares of Alibaba (trading up 36 percent in its debut) indicate speculation and excess, or is the S&P 500 at over 2,000 simply a marker on the path to further gains? Judging by the amount of retail investor cash on the sidelines and what appears to be an accelerating rate of economic growth domestically, we believe that equity valuations are reasonable. Our call is for stocks to track rising earnings and outperform bonds as the Fed pares its program of QE and ultimately starts raising interest rates next year.
All of which brings us to the details surrounding Yellen & Co.’s Fed meeting this week. Investors expected QE to be trimmed again, but the question for many investors surrounded the language with which Yellen would describe the timeframe between QE termination and the onset of rate increases. Juxtaposed against another benign inflation reading reported earlier this week (1.7 percent on the CPI), considerable time was retained as the Fed’s operative phrase. And why not? Commodity prices are dropping thanks to the stronger dollar and weaker growth from China, while unit labor costs are well contained at +2 percent. Recognizing that the Fed operates under a dual mandate to limit inflation to 2 percent and promote full employment, the error of estimate seems to be lower in deciding how fast the Fed raises interest rates, acknowledging that the 6.1 percent level of unemployment most likely overstates the degree of labor market tightness because labor force participation is so low. So is the market for Fed Funds futures correct in undershooting the FOMC committee’s collective prediction that short-term rates will rise to 1 3/8 percent by the end of next year? Only time will tell, but we believe that the Fed remains dependent on the tenor of incoming economic data to determine how fast rates will normalize.
Approaching Quarter End
With the Fed meeting behind us, a spattering of odd lot earnings reports this week from the disparate ranks of Fed Ex (good numbers, stock up), General Mills (bad numbers, stock down), and Oracle (disappointing numbers, stock down) has investors beginning to consider what could become of the next earnings parade that will start in just a few short weeks. We see puts and takes. Inasmuch as the U.S. economy is outperforming other regions at the same time the trade-weighted dollar has surged, U.S.-centric companies stand a better chance of meeting and/or exceeding estimates. In contrast, larger multi-nationals could struggle with currency translation and economic headwinds from a moribund European economy and slowing growth in China.
Our Takeaways from the Week
- Stocks remain well bid as investors come to grips with the prospects for Fed tightening next year
- Third quarter earnings season is right around the corner amidst currency headwinds for multi-national corporations