The markets are not being terribly logical and they are not expected to be logical in the short-term either, says David Kelly, Chief Global Strategist at JP Morgan Funds.
Though the markets have remained volatile in recent times, fundamentally, the US economy has improved, Dave noted. Also, since the labor participation rate is falling, the unemployment rate will gradually come down with the current pace of economic growth.
However, none of these numbers change the fact the Fed will be forced into tapering the QE. The Federal Reserve can’t continue to buy bonds at a pace of $1 trillion every year and later this year or early next year, they will have to taper the program. As they do that, long-term rates will go up. Rates (or bond yields) may fall on a few occasions in the short run, but ultimately investors should position themselves for a rate hike over then next few months, he added.
Asked how long investors have to grapple with the present uncertainty before there’s some stabilization, Dave said although the Fed meets next week, he doesn’t expect any change in messaging from them, because they don’t want to talk about tapering now or how to go about it.
But, by September, they need to think about setting a path for reducing the bond purchases because the bigger the Fed’s balance-sheet grows, the tougher it becomes for them to dismantle it.
It’s like they got a tiger by the tail in the bond market now and they keep on feeding it which keeps it calm. But the tiger is getting bigger and when it grows it’s going to bite hard. So it’s very important for the Fed to plan an exit strategy when the economy is improving.
The Fed’s going to be on the same path in the short run and investors should not overreact to daily economic data, which just swings either way though recent retail sales and unemployment claims data have been encouraging, he said.
Asked how investors should position themselves in preparation for a tapering situation, David said investors should be slightly overweight on equities than fixed income. In equities, US companies are preferred with some exposure in emerging markets for the long run.
Investors should be light on utilities because performance is going suffer if interest rates go up over the next few years. They should be a little overweight on information technology.
Within the fixed-income market, investors should focus on short duration bonds because there are not too many TIPS, Treasuries or high-quality corporate bonds, he observed.
Asked to comment about the emerging market stocks, David said the asset class is running into different problems right now. While China is clearly trying to transition growth, India and Brazil are struggling with inflation problems.
However, commodity consuming countries are preferred over commodities producing countries. That being said, valuation remains the most important parameter for investments and a lot of emerging markets are trading quite cheap, at less than 10x PEs.
There are a lot of great companies in those markets and this is where growth is going to be over the next few decades. Emerging markets are going to absolutely drive the world in terms of growth, he added.
Asked to elaborate on the kind of growth he was referring to, David said the growth will be in manufacturing, exports and the consumer sector. Consumer companies in countries like Indonesia and Mexico, whose economy is growing at 5, 6 or 7 percent, and Asean countries in general, will show earnings growth over the next few years. So investors need to take a longer-term perspective even though these countries were running into short-term headwinds, he concluded.
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