Fed's inertia is good news for UK and Europe's stock markets

EVER since leading indicators such as purchasing managers&rsquo; indices started showing signs of a recovery in the global economy, market participants have been watching the actions and comments of central bank policymakers closely for signs that their extra-accommodative monetary will be tightened in due course. <br /><br />But while an acknowledgement that the recovery is entrenched enough to start reversing loose monetary policy would be good news for both the economy and the stock markets, the US Federal Reserve&rsquo;s lack of activity since last December is actually benefiting UK and European equities. Or so argue Evolution Securities&rsquo; analysts Philip Isherwood and Brennan Leong in a fascinating research note.<br /><br />Using data going back to 1973, their research shows that the average monthly return from UK equities is 77 basis points and 74 basis points from European equities. But in months when the Federal Reserve has cut interest rates, average monthly returns for UK and European equities surge to 184 basis points and 150 basis points respectively. <br /><br />In contrast, months with unchanged Fed rates see the lowest monthly rates in UK stocks: exactly 49 basis points compared to 61 basis points when rates are rising. <br /><br />However, and worthy of note by contracts for difference (CFDs) traders, &ldquo;isolating periods of extended pause (longer than six months) shows the longer the Fed is on hold the more the market likes it&rdquo;. During these periods, investors have seen an average monthly return of 108 basis points, and as much as 140 basis points if the pause follows a period of falling Federal Reserve rates. <br /><br />Isherwood and Leong say that it seems intuitive that the more the Fed is convinced it doesn&rsquo;t have to do anything because policy is having the desired effect, the more confident the market can be that things are running smoothly. <br /><br /><strong>EXTENDED PAUSE</strong><br />Indeed, only three of the 12 periods of an extended pause in interest rates since 1973 have resulted in a subsequent negative return in UK equities.<br /><br />With the Fed expected to keep rates on hold until October next year, CFD traders could, on the assumption that this correlation will hold true again, take out a long position on the FTSE 100 index expecting profit over the medium term. <br /><br />However, bear in mind that this does not exclude the possibility of a pullback in the markets over the next couple of months. Stop losses should therefore be set appropriately &ndash; but at a comfortable level &ndash; in order to cushion any falls in the index. <br /><br />But while indices provide a diversified&nbsp; bet on equity performance, CFD traders could realise an even greater return on their positions by taking positions in sector CFDs, which also have historically shown clear winners and losers from an inert Fed policy. <br /><br />Based on periods since 1980 when the Fed has been on hold for longer than six months, sectors such as industrial metals, mining, automakers, and technology have tended to outperform their averages by a significant margin. <br /><br />In the nine months to date that the Fed has kept interest rates at 0.25 per cent, the industrial metals sector has outperformed its average return by an astonishing 280 per cent. <br /><br />Historically, the mining, autos, and technology sectors have also outperformed on average when the Fed is on an extended pause &ndash; although not by the 54, 48 and 40 per cent that they have experienced during this cycle. <br /><br />Their relative outperformance compared to the long-run average would suggest that these should both weaken from here to return towards the long-run average. <br /><br /><strong>CUTTING POSITIONS</strong><br />A recent survey of global fund managers by Bank of America-Merrill Lynch (BoA-ML) showed that those based in the UK were neutral on both basic resources and industrial goods and services. Globally, fund managers cut their positions in industrials by 5 per cent in September compared to the previous month. <br /><br />Most crucially for savvy CFD traders looking to select carefully which sectors to take positions in, Evolution Securities&rsquo; analysis shows that the sectors that have historically outperformed most beyond week 37 of the pause cycle &ndash; where we are now &ndash; are telecoms, technology, utilities and banks and financial services. <br /><br />These could well be the specific sectors on which to take your punt as the pause in Federal Reserve rates heads towards its latter stages.&nbsp; <br /><br />At a European level, the BoA-ML survey reveals that a net -17 per cent of fund managers think banks are the most undervalued, while telecoms and technology are also seen as undervalued, by a net -16 per cent and -10 per cent respectively. Consequently, these are the two sectors on which European fund managers are the most overweight, a 19 per cent increase on the previous month for telecoms. <br /><br />With the Fed widely expected to do nothing until at least this time next year, these correlations could well give CFD traders some useful insight on how best to play the UK equity markets until monetary tightening is underway. <br />