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A New Environment for Investors

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Investors may benefit from one thing that every kid knows: Whoever owns the ball sets the rules. When it comes to the U.S. financial system, the Federal Reserve owns the ball. Therefore it pays for investors to know the rules the Fed is imposing on the American economy.

At the moment, rule #1 is slow down.

Over the last year, rapid economic growth and soaring energy costs have pushed core inflation above the Fed’s target range of 1% to 2%. Including food and energy, the recent three-month rate of change in the consumer price index is the highest in a decade. Because energy prices are likely to remain elevated for the foreseeable future, the only way to reduce inflation is to restrain growth.

After 17 interest-rate hikes, it appears the Fed has accomplished that goal, though inflation still remains somewhat elevated. Looking ahead, the biggest question is how investors will react to the deceleration in profits growth that will almost certainty accompany the deceleration in economic growth.

A new environment
In focusing solely on the U.S. equity market, there are specific sectors, industries and stocks that appear poised to outperform given these negative circumstances.

Undoubtedly, stocks in areas that are dependent on robust consumer spending—like many retailers, restaurants, leisure and auto- and housingrelated companies—should be de-emphasized within investor portfolios. How, then, should equity portfolios be positioned to capitalize on a slowing U.S. consumer? Here are three favorable themes for portfolio allocation:

1.Capital spending. Business spending should continue to grow, as companies need to replace aging capital stock, invest in plant and equipment and upgrade existing technology. Sectors that are currently showing strong and/or consistent capital expenditure growth include Industrials, Information Technology, Energy and Materials.

2.A weaker U.S. dollar. Companies that generate a substantial portion of revenues from outside the U.S. should benefit if the dollar weakens, as Merrill Lynch currency strategists expect. Potential industry groups that could benefit from a weaker dollar include Chemicals, Containers and Packaging, Gold, Building Products, Industrial Conglomerates, Machinery, Apparel and Footwear, Hotels, Personal Products, Internet Software and Other Electronics.

3.Favorable commodity outlook. Demand for commodities from fastgrowing emerging markets—coupled with supplies that are constrained by either a lack of available resources or manufacturing processes that require long lead times—should be a positive for commodity producers. Potential favorable sectors include Aluminum, Chemicals, Gold, Oil and Paper.

The bull lives?
The good news is that if history is a reliable indicator, the bull market in stocks that began in late 2002 could have farther to go. Assuming the Fed reins in inflation without squelching the expansion, financial conditions should support still-higher stock prices.

Yet this first decade of the new century is also likely to be an era that generates modestly below-average overall returns for equities. The excesses of the technology bubble have to be worked off—a process that is well underway, but likely still not complete. That suggests it’s more important than ever for investors to focus on those areas that appear best positioned to generate solid returns.

As the U.S. economy decelerates in fits and starts over the next several months, it is possible that the old leaders will still enjoy brief spurts of outperformance. But they will likely be brief.

Remember, the Fed wants the economy to slow down—and the Fed owns the ball.

Brian Belski is the senior U.S. Sector Strategist at Merrill Lynch.