Can the Fed hurt stocks

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By :  ,  Financial Analyst

The Federal Reserve will conclude its meeting this evening and announce its latest decision at 1900 BST. The market expects no change in rates, and there is no press conference from Janet Yellen, so the focus will be on the statement.

There is a tendency to view Fed meetings without a press conference as a non-event, however, we think that this statement could be important for markets. Although we don’t expect the Fed to make any big announcements today; for example when it will shrink its balance sheet or its future move on interest rates, its overall economic assessment will be worth noting. US data disappointed in Q1, and the Citi economic surprise index for the US has fallen to its lowest level since October last year. If the Fed hints that it will remain on hold because it is downbeat on the future prospects of the US economy, then investors are unlikely to be emboldened to continue buying stocks.

A tough question for investors:

The outcome of this Fed meeting could pose a tough question for investors’: how do you reconcile stocks at record high levels with a Fed remaining on hold because it is concerned about future growth prospects? It is hard to justify a further push higher in stocks, especially when valuations are already high (see chart 1), when the growth outlook is not accelerating.

A difficult spot for stocks:

There was another record high for the Nasdaq on Tuesday, yet Apple results were a touch disappointing and the lead indicators are showing signs that they are rolling over; for example the Russell 2000 has had 3 days of declines out of the last 5. The Dow Transports index has also missed out on the latest push higher in US stocks, and last peaked on 1st March. The market is starting to look tired, and a Fed that is downbeat on the economic outlook could be enough to spook investors and trigger a larger sell off.

An ominous sign from the Vix

It’s also worth noting that an 11 year low in the Vix, reached on Monday, is also an ominous sign. For how long can the Vix be supressed, especially if the outlook for the economy is starting to deteriorate?

Overall, while we don’t think that this Fed meeting will tell us anything new about the future direction of policy, it could still leave its mark on the market. If the Fed sounds downbeat on economic growth then stock indices could be in for a fall.

A note on Valuations:

The chart below shows the Price/ Earnings ratio of the S&P 500. Although valuations have dropped slightly since January, they remain at their highest level since 2002. Without an accompanying strong economic outlook, it is hard to see how this can be sustained.

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