The U.S. Federal Reserve’s plan to raise interest rates more slowly than previously anticipated certainly pleased investors and there are several explanations why.
For one thing, a lower Fed funds rate outlook for 2015-2016 reduces the risk of a further U.S. dollar surge and oil price collapse. But Deutsche Bank strategist David Bianco also believes it douses the threat of a 10% correction for that S&P 500.
“It also increases the likelihood of a P/E expansion within the full span of the year,” Mr. Bianco told clients, noting that this outcome is much more likely if EPS is positive and GDP is above 2.5%.
The strategist thinks it might push the S&P 500’s trailing P/E to between 18x and 19x by the end of 2015 from roughly 17.9x currently. Yet he cautioned the index remains at risk of a 4%-to-8% dip this spring because of year-over-year EPS declines in the first quarter with the third quarter.
In a predicament with slow Fed hikes that materialize throughout 2016, stopping around 2% on decent GDP growth, benign inflation and a 10-year treasury yield below 2.5% at the end of 2015, Mr. Bianco thinks a fair trailing P/E for that S&P 500 could be 18.5x. Which includes a valuation of 15x for that financials and energy sectors, and 20x for the rest of the index.
The strategist sees the most P/E upside in sub-20x P/E sectors that may deliver decent EPS growth, despite the massive currency headwinds present in 2015, coupled with solid growth though the rest of the cycle – technology and healthcare in particular.
He noted the lowered Fed funds rate outlook is pushing 10-year yields lower, so utilities could also recoup a lot of their 15% underperformance in February.
Mr. Bianco remains overweight both utilities and telecom, as these bond substitutes don’t possess the foreign exchange drag contained in the consumer staples sector.
He’s also overweighting big banks as both value and dividend growth plays, as well as other financials that are rate responsive to the Fed funds rate. However, the strategist said a rate hike liftoff in September or later “could frustrate investors given the ongoing net interest margin pressures and could delay upside.”