I was having one of my regular discussions with my father today, over a cup of coffee, on the current state of equity markets. His question to me was, how much of the rise in equity markets can you attribute to quantitative easing, and if the relatively modest adjustment to US monetary policy brings this response, what is the outlook for equities if the US Federal Reserve continues to tighten monetary policy? A question that many investors will be debating.
I always take heed of my father’s intuition, he spent many hours in the early days of 2007 asking how we could prepare for what he saw as an impending bear market. He also ensured I sold my vested Citi shares before the banking crisis truly took hold, by using good old-fashioned logic.
We have all seen the charts that show the correlation of equity markets to the Fed QE policy, I have produced them in this blog in the past. Is the bull run in equities now over the Fed is starting to ease back? That is the ultimate question. My immediate response was, I hope and think not, and here is my rational.
At some stage the Federal Reserve had to begin tapering its monetary policy, the fact that it can start to be wound down is almost a confirmation that it has achieved its goals. The equity and bond markets need to go back to the fundamentals that drive them, global growth and earnings.
Firstly, I went back to 1994 and the unexpected rise in US interest rates (previous blog on this). The Fed kept tightening that year as the US economy picked up steam. The S&P 500 initially fell approximately 10% and marked time for most of the year. But once the initial shock was overcome, the ensuing 6 years saw the S&P 500 rally over 300%, with the usual hiccups along the way. One could argue bonds also reacted in 1994 in a similar manner as to today. Yields rose sharply as they have done over the past 6 months and then settled back down again. The slight difference being US treasury yields went from just under 3% to nearly 8% and back to 4%, as opposed to from 1.5% to 3% as they were at the start of 2014.
Secondly, equity valuations, whilst not as attractive as they have been are still not totally out of kilter with history. Interest rates are unlikely to be rising any time soon, and whilst there has been some rotation from bonds to equities over the past year, equity weightings as a portion of a balanced portfolio remain below historic-norms. The IMF recently modestly upgraded their forecast for global growth, and so far, the earnings season is not causing alarm bells to ring.
Other similarities of 1994 to today; at the point the Fed moved, the S&P 500 was hitting an all time high of 480 points. Two years later, when the S&P 500 was approximately 200 points higher, Alan Greenspan, the incumbent Chairman of the Fed, made his famous remark about the irrational exuberance of equity markets. The equity market dipped for a couple of days after the comments but went on to double from that point.
We should remember that since 1994 we have lived through some unique events in history: the arrival of the internet leading to a technological revolution; the creation of a currency union, the break of which would now have an untold impact on the global economy; and a banking crisis that saw the end of a bank that had existed over 100-years, survived two world wars as well as the depression of the ‘30s.
As we concluded our coffee and our discussion, we decided one should look through the short term and accept the introduction of QE will have had an impact, as will its withdrawal, but that impact should not be exaggerated and should be taken into context with the size of the global economy. Equities are volatile by nature and these unusual times are going to create periods of uncertainty. But one thing that has remained consistent through history — buying and holding blue chip companies, with decent yields and strong balance sheets has proven a winning strategy.