When the Punch Bowl Goes Away

Even though the Federal Reserve didn’t raise interest rates this week, the government inches closer to raising interest rates and ending massive stimulus programs. What are the risks for the market? These brokerages weigh in.

Who’s Talking: Liz Ann Sonders, Chief Investment Strategist, Charles Schwab

The Gist: The Federal Reserve will raise interest rates sooner than later, which isn’t all bad.

Investors are increasingly concerned about when the economic recovery is going to become “self-sustaining,” says Sonders. Even though it didn’t raise interest rates this week, the Federal Reserve has already begun to pull back on its monetary and fiscal stimulus measures, and the federal government has allowed programs such as cash for clunkers to expire. The key to determining how the economic recovery plays out will be the market’s reaction to these stimulus pullbacks, says Sonders. The good news is, programs like cash for clunkers don’t typically have much impact on sustainable economic activity; they merely “pull demand forward a bit,” which means their withdrawal wouldn’t do much to depress long-term economic activity.

Sonders’ main concern, she says, is continued government spending, which, along with possible regulatory changes for the financial sector, could result in “renewed pressure on the economy.” There’s also the risk of inflation, which will require the Fed to remove its monetary stimulus soon enough to prevent it but not too soon to avoid dampening the economic recovery. It has already taken steps in this direction, says Sonders, by allowing its Treasury and mortgage-backed securities purchase programs to expire soon. But the bigger question is when the Fed will raise interest rates, which she says will be sooner than many believe, perhaps by the first quarter of 2010. That’s not necessarily bad news, however, since it would be worse if the economy actually necessitated 0% interest rates for a prolonged period. Even lifting rates to 2% in a series of Fed moves wouldn’t be so bad, representing “an extremely low level when viewed in a historical context,” she says.

Meanwhile, the dollar decline has signaled an increase in investors’ risk appetites as they sell U.S. dollars in favor of riskier investments. But investments that bet on dollar weakness are likely to reverse, says Sonders, which will lead to “countertrend rallies in the dollar.”

What does that mean for investors’ portfolios? They should include an international allocation to factor in the long-term downward direction of the dollar. But, says Sonders, keep in mind that international markets are also likely to pull back from their strong run this year if the dollar rises.

Who’s Talking: David Bianco, Chief U.S. Equity Strategist, Bank of America/Merrill Lynch

The Gist: The risk of surging interest rates poses the biggest threat to sustained market gains.

The interest rate outlook is “now the biggest source of uncertainty,” says Bianco, who is concerned about a sharp rise in rates. Though he is confident in the sustainability of the global economic recovery, he says the 5% pullback in the midst of a strong earnings season has led him to revisit the key risks along the way.

Bianco does not expect an inflation problem, he says, since unemployment is “near post-Depression highs and capacity utilization is near post-Depression lows.” The Fed also isn’t likely to make repeated mistakes in its monetary policy that would lead to chronic inflation. U.S. consumers are also saving more and spending and borrowing less, which should keep interest rates low. Many investors still fear higher interest rates, though, because of the government’s trillion dollar deficit problem and the lack of a government plan to curb deficit spending. This condition has investors fearing an “unlikely combination of runaway deficits, much higher taxes and deep spending cuts.” But Bianco says he only expects “some of each but not a lot of all.”

Even if interest rates do rise moderately, Bianco says his team is sticking to a 12-month S&P 500 target of 1200. The Fed will likely refrain from raising interest rates through 2010, he says, which makes financial stocks look attractive, since low short-term rates keep costs on bank deposits low. The sector does risk a sharp rise in long-term interest rates, which would threaten short-term rates, damper growth and put pressure on the real estate market. A slower rise in long-term rates would actually benefit banks, though, providing a steeper yield curve to earn high interest margins.