The Federal Reserve is likely to raise interest rates in June 2015 as economic data has been pretty soft in the last few weeks, said David Joy, chief market strategist at Ameriprise Financial. However, eventually, markets are likely to witness a 10 percent correction in anticipation of a rate hike, possibly by the end of the year, David added.
Latest Consumer Price Index data showed inflation remained unchanged in August for the first time in more than a year. Asked if price pressure has lost momentum and inflation has bottomed out, David answered in affirmative. There is very little inflationary pressure either at home where the economy is expanding at a faster clip, or in Europe, where growth has been more sluggish.
That gives Janet Yellen a lot of room to run and buy some time to get the unemployment rate down to where she wants it. It’s kind of best of all worlds for the Fed right now, as wages are not moving up fast enough yet, he observed.
Earnings growth has been modest this year, and a lot of companies have used “share buybacks” to juice returns. However, compared to historical standards, buybacks have slowed considerably this year. Asked if the waning trend indicates companies believe the benefits of buybacks have reduced, David said shrinking buybacks could also indicate a reduction in free cash flows.
If wages start to rise, more of the cash-flow is diverted to the employee-base. Also, there is an increase in capital expenditure by companies, which could eat up the free-cash flow. Investors should understand that buybacks are important, but they are no substitute for good operating performance. If a company displays both, then a stock can outperform, he observed.
Asked what sort of a scenario is likely to play out in the short-term for a 10 percent correction to take place, David said there two possibilities. One, economic data shows the US economy is stronger than it has been in the last couple of weeks, and the nonfarm payrolls rate accelerate where suddenly the fear of a faster Fed rate-hike cycle comes into play.
The other scenario is the opposite; growth is much-more sluggish than people anticipate and there is a “growth-fear”. The economy is in the middle of the two extremes and that is providing some real support to the equity market. So the correction, as the Fed says, is really “data-dependent,” he explained.
Asked to explain his preference for financial stocks, apart from tech and industrials, in a potentially rising interest-rate environment, David said rising interest rates help banks to improve their net interest margins.
Higher rates also help insurers and asset managers. It won’t help every aspect of the financial community, but it will help a wide area of them. The bottom-line for financials is that a better economic backdrop leads to more activity.
A lot of regulatory overhang has been put behind, especially in the banking system. Financials in-general can do a little better as long as the economy is improving, he concluded.
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