Recent Fed Meeting’s Outcome Offers Mixed Results

OCEAN CITY — Economic and policy developments in the world’s largest two economies have been center stage. In the U.S., it was hoped the recent meeting of the Federal Open Market Committee (FOMC) would provide clarity on the Fed’s policy views. Unfortunately, this was not the case. Further east, Chinese economic data for the first few months of 2014 has come in much weaker than expected, adding to the unfavorable news of a first corporate bond default in the country. The tradeoff between growth and policy across these economies is a key area to monitor, in our view.

Our positive equity market view this year is anchored on expectations of improving economic growth through 2014. We have been encouraged by slightly better indicators, including reports in recent weeks on labor, manufacturing, capital investment and spending. Another central basis of our positive outlook is still accommodative monetary policy by the Fed through this year and into 2015. The Fed began tapering its monthly bond purchases at the end of 2013. The central bank announced another $10 billion reduction last week. Of greater interest is the Fed dropping its quantitative threshold for initiating rate hikes in favor of qualitative guidance. The Fed identified a broader set of economic indicators that range from employment to inflation to financial stability. It included a decisive line in its policy statement: “The change in the Committee’s guidance does not indicate any change in the Committee’s policy intentions as set forth in its recent statements.” So far, so good.

However, what the Fed gives with one hand, it takes away with the other. At the same meeting, it indicated where members believe interest rates will be over the coming years. The surprise here was that compared to December, more officials believe the first rate hike will take place in 2015. And the median expected policy rates were 1.00% at the end of 2015 and 2.25% at the end of 2016. That’s a collective 0.75% increase once the Fed begins to hike. At the same time, Fed officials didn’t upgrade their growth forecasts over the next three years and see inflation gradually rising towards 2%. Bank of America Merrill Lynch (BofAML) Global Research believes disinflation risks in the U.S. are still significant, and view the risk that inflation comes in below the Fed’s forecasts as driving

accommodative policy for some time still.

Unsurprisingly, the market found the FOMC meeting more hawkish than previous ones. Equities retreated and bond yields moved higher. The U.S. dollar rallied, a trend we expect to continue as investors discount the prospect of the first rate hike earlier in 2015. To us, the majority of market moves reflect the sensitivity of investors to every word from the FOMC. Unfortunately, this is unlikely to change in the coming months.

We prefer not to change our guidance over such details. Our preference, therefore, is to focus on what we can influence – first ensuring investor’s allocations are consistent with their investment goals, then guiding portfolios towards opportunities consistent with our outlook. As this remains a still-improving economy, these views continue to favor equities over fixed income. After all, the week still ended with equities higher and Treasuries lower.

(A Merrill Lynch Wealth Management Advisor who can be reached at 410-213-8520.)