Before The Bell - The major equity averages are looking at a lower opening today. This comes on the heels of yesterday’s volatile session, which saw the market sell off into the Federal Reserve’s monetary policy decision (at 2:00 P.M. EDT) and then hold a portion of those losses into the closing bell. The bearish mood is a reaction to the FOMC statement, which showed that the central bank may consider raising rates sooner than expected, with perhaps two monetary tightenings ahead of the timeline provided last year. The strongly recovering output and jump In pricing that has accompanied it—the Fed upped its 2021 inflation estimate from 2.4% to 3.4%--has brought concerns about an overheating economy and a less accommodative central bank down the road, the latter of which has historically not been an ideal backdrop for equities.

Looking at yesterday’s developments more closely, the Federal Reserve made no short-term changes at its two-day meeting. It kept interest rates near zero and announced that the $120 billion-a-month asset purchasing program will remain in place for the time being. Those decisions were not surprising, but what unnerved investors was the aforementioned inflation outlook and the perception that the lead bank is becoming a bit more hawkish on monetary policy. In fact, the Fed statement showed that seven District governors now foresee an interest-rate hike in 2022, up from three at the prior meeting. The bank also raised the overnight repo rate for banks by 50 basis points, which is one under-the-radar way of slowing the pace of lending and trying to keep the economy from overheating.

Sticking with the economic theme, this morning we received some more data from the business beat, though it is clearly being overshadowed by the Fed news. Specifically, the Labor Department reported that initial weekly unemployment claims came in at 412,000. The expectation called for a figure in the neighborhood of 370,000. This miss may give some more weight to Federal Reserve Chairman Jerome Powell’s comments yesterday that more work needs to be done in the coming months to improve the labor market situation. 

So what are investors to do following yesterday’s news? We would recommend that they keep a high level of equities in their portfolios. In his prepared comments yesterday, Chairman Powell did say that he expects the central bank to remain accommodative through 2023 and that he still thinks the recent inflation is the product of transitory factors, stemming from pent-up demand with the economy reopening and bottlenecking in the supply chains. Chairman Powell noted that lumber prices, which have been a major contributor to the higher prices of late, have started to ease in recent weeks, and could be a sign that once the supply-chain issues are rectified, inflation will look more benign. If the central bank’s pricing assumption proves correct, it may provide a nice boost to stocks, particularly those in the high-growth sectors like technology. The large-cap technology names may offer the best combination of growth and safety for those with a longer-term investment horizon. That said …

The “inflation trade” may still be a worthy near-term investment strategy. The materials sector, which has performed well over the last year, and the banking sector, which has been among the laggards of late, may be two groups to give a closer look. The possibilities of higher interest rates and rising bond yields would be a positive for the earning power of banks, and when coupled with a sharply recovering economy, could amount to a perfect storm for a number of the larger lending institutions. It should be noted that some of the banking names did well after yesterday’s Fed news. The energy stocks also may be a good near-term play, as a fully open U.S. economy, which would include a drastic pick-up in travel and strong industrial production, will likely lead to increased demand for crude oil and gasoline. (Tuesday’s report on industrial production showed a healthy increase in activity last month.) Likewise, an economy with no restrictions from COVID-19 may provide a nice backdrop for the retailers, restaurants, and recreation companies. This may work in the favor of the consumer cyclical stocks, many of which were notable laggards in 2020 and are still trading at attractive valuations in a market that is otherwise looking frothy to many observers.  – William G. Ferguson

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.