Investors have been enjoying a stimulus fueled rally on Wall Street and their concerns about the end of this historically ultra-low rate environment has rightfully rattled their confidence. The debate between whether or not the stock markets’ run-up is entirely a result of the Fed’s unprecedented monetary policy rages on; bearish pundits point out that the recent sell-off sparked by bond-repurchase talks on 5/22/2013 is a testament to the fact that the Fed’s Quantitative Easing is the single most important driver of equity prices.
On the other hand, the bulls cite a number of “real” economic improvements in the housing and consumer markets that suggest the Fed cutting stimulus won’t really derail the recovery. Whatever the case may be, the one thing for certain is that the end of “easy” monetary policy is sure to have a meaningful impact on investors’ sentiment and expectations, and more importantly on how and where they position their assets [see The Complete Visual History Of SPY].
With the end of QE now on the horizon, and on investors’ minds, many are scrambling to re-position their portfolios in anticipation of rising interest rates. While a rate hike is bound to happen, the scenarios that can pan out beforehand may have an even more meaningful impact on asset prices. More specifically, the Fed has laid out a crude game plan for starting to scale back on bond-repurchases in September if economic data warrants it [see Want A Simple, 3-ETF Portfolio? Here Are 25 Of Them].
In an effort to simplify the speculation game that looms, below we have laid out three scenarios that may manifest themselves as the end of QE inches closer. Since the Fed’s policy action is data-driven, the scenarios outlined below revolve around the notion of what may happen with economic conditions:
1. Economic Data Remains Largely Unchanged
This scenario is likely the one that is most anticipated at the moment. Economic data is largely mixed right now; housing and manufacturing are recovering while the labor market remains under pressure. If the current trend of solid, but not stellar, economic data releases persists, then the Fed should stick to its recent announcement and start to gradually scale back on bond-repurchases.
- U.S. equities may turn lower initially after the taper, but Small Caps should resume their ouperformance as investors realize the Fed is actually affirming that the economy is improving on its own
- Treasuries will likely suffer as demand for safe havens wanes
2. Economic Data Gets Much Better
If economic data shows a surprisingly strong uptick in employment–a closely watched benchmark by the Fed–policymakers could feel pressure to scale back on stimulus further than previously expected. An unexpected surge in employment may prompt the Fed to pull out quicker than expected as inflation concerns would likely replace slow-growth fears.
- Cyclical sectors, including Financials, Industrials, and Technology, should lead the way here as improving growth prospects bolster discretionary spending
- Investment Grade and High Yield Bonds will likely tumble further as investors increase their risk appetite on the equity front
3. Economic Data Gets Much Worse
This scenario is undoubtedly the least likely one of the three, and as such, it could have the biggest impact if it actually pans out. If employment data deteriorates and China and Europe slow down even more, policymakers at home may feel pressure to not only keep the bond-repurchases unchanged, but perhaps even up the stimulus ante. The last FOMC statement hinted at the fact that the Fed will adjust stimulus measures based on the economic conditions; while many assumed this hinted at scaling back on stimulus if data improves, few considered the possibility of worsening conditions that could prompt further QE from the Fed.
- Defensive sectors like Consumer Staples and Utilities that have fallen out of favor recently could stage a comeback as investors scale back on risk in the equity front and ditch cyclical securities
- Treasuries and TIPS could rebound big time if the Fed surprises everyone with increased stimulus
- Gold prices could spike higher if additional QE is announced as inflation and “money printing” fears once again resurface
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Disclosure: No positions at time of writing.
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