Stock of the week: What to trade if the Federal Reserve turns hawkish
The main event this week is the Federal Reserve meeting that will conclude on Wednesday. After the last meeting in September, the Federal Reserve had shifted to a more hawkish stance, with more FOMC members expecting to see rate increases in 2022. Expectations are high that the Federal Reserve will start tapering, or reducing its pandemic-era asset purchases, at this meeting. That is widely expected by the market; however, the most important part of this meeting will be how hawkish Fed chairman Jerome Powell sounds when he delivers this message. There is a chance that the Fed chair might err on the side of caution as inflation readings in the US are posing a problem for the Fed. The latest reading of the Fed’s preferred measure of inflation, the PCE index, rose to an annualised rate of 4.4% for the headline rate, and remained steady at 3.6% for the core rate. Added to this, wage growth in the US has also risen at an astonishing rate, the Employment Cost Index rose at its fastest pace quarterly pace in more than 30 years for Q3, while wage costs rose by a 6% annualised rate, the highest level for nearly 40 years. As you can see, a lot is resting on a hawkish Fed and the aftermath of this week’s meeting could have a big impact on stock prices.
Below, we take a look at three sectors that could do well in an environment where the Federal Reserve shifts to a more hawkish stance.
1) Companies with dollar earnings
When central banks shift into hawkish mode, it usually helps to boost the domestic currency. The dollar ended on a high last Friday, after making strong gains versus the euro and the pound, GBP/USD saw its largest intra-day decline in a month. This dollar strength was put down to weak market sentiment (the dollar is a safe haven), the news about the employment cost index, month-end flows and some dollar buying ahead of the FOMC meeting. The dollar index is currently at its highest level since October 2020, but there could be further upside and dollar strength is fast becoming the main theme for the FX market. If traders need to plan for a prolonged period of strength in the greenback then we need to look at companies that will benefit from a strong dollar. The obvious candidates are oil companies who earn the vast bulk of their earnings in US dollars since oil is priced in dollars. Last week Exxon Mobil reported its highest earnings figures since 2017 on the back of a soaring oil price, it also promised to resume its share buyback programme next year. Chevron posted its highest quarterly profits for 8 years, after its earnings were boosted by higher output and a higher motor fuel prices which boosted refining margins. A backdrop of a stronger dollar, strong Q3 earnings, strong commodity prices and decent valuations makes energy firms a favourite if the Fed strikes a hawkish tone this week.
2) Consumer discretionary
We mention above that annual wage growth is rising at its fastest rate in nearly 40 years, according to the US’s Employment Cost Index. A tight labour market coupled with strong wage growth is good news for the consumer discretionary sector as it means that more people have extra money to spend on higher price or covetable objects. If the Fed does shift to a more hawkish stance this week then it will be because of stronger economic growth and a buoyant economic backdrop, which is good news for the consumer discretionary sector. The US has some of the world’s largest consumer discretionary companies including such diverse names including GameStop, McDonalds and Nike. eBay and Footlocker are also consumer discretionary stocks, and these two companies have some of the lowest P/E ratios in the sector, which could boost their attractiveness in the coming weeks.
3) Bank stocks
Earlier this year, US stocks tanked when the Fed signalled that it could raise interest rates at a faster pace than had been expected. However, bank stocks continued to rise. Thus, we already know that US banks are resilient in the face of a more hawkish Fed. Financials have been on a winning streak in recent months, with JP Morgan rising to an all-time high last week and October was a strong month for the S&P 500’s financial sector. Some think that the Federal Reserve has not been hawkish enough in its communication, thus, if the Fed takes a major step in a hawkish direction at this week’s meeting, then this could trigger another leg higher in US Treasury yields, which could lead to even more strength for US bank stocks, including JP Morgan. It is worth remembering that rising Treasury yields is good news for bank stocks, as this can push up interest income that they earn from mortgages and other loans. Thus, it is worth watching the reaction in the Treasury market after this week’s Fed meeting. At the end of last week, the 10-year US Treasury yield was 1.55%, the 2-year yield was 0.48%. If there is a major shift upwards in these yields, then US bank stocks may benefit.