The biggest risk facing global markets today is a mistake in monetary policy by the Federal Reserve or the European Central Bank (ECB), according to Bank of America Merrill Lynch's latest monthly fund manager survey. With central banks beginning to rein in stimulus after almost a decade of extraordinarily loose monetary policy, are fund managers right to be worried?
Central banks’ quantitative easing (QE) policies have resulted in them buying government bonds to the tune of $11 trillion over the last decade in an effort to keep interest rates at rock-bottom levels.
The unwinding of these emergency measures is now under way. In the US, increased economic stability has allowed the Federal Reserve to raise rates twice this year, and it expects to reduce its balance sheet by $450bn by the end of 2018. The ECB has promised to keep buying bonds until inflation increases, although that may change: last month, three influential ECB board members reportedly argued for a less loose monetary policy.
Outgoing Fed chief Janet Yellen likes to say the unwinding of QE will be like watching paint dry. Not everyone is so sanguine. Earlier this year, MKM Partners cautioned that five out of six previous episodes of balance sheet shrinkage ended in recession, while 10 of the last 13 tightening cycles have ended in recession. Renowned value investor Howard Marks, who correctly warned in 2000 and 2007 that stocks could crash, is also fearful.
Marks isn’t worried about historical precedent, but the lack of it, saying that “we are in unchartered territory with all these central bank policies” and that “we can’t say what will happen”.
Bears often point to charts showing how stocks and the Federal Reserve’s balance sheet have moved in sync since 2009, with stocks screaming higher as the Fed expanded its bond holdings.
“The extrapolation appears dire,” writes Deutsche Bank analyst Luke Templeman. “As the Federal Reserve shrinks its balance sheet, stock prices are bound to drop.” However, he adds that this thesis may be confusing correlation with causation. Before concluding stocks will be hurt by the withdrawal of stimulus, one must first ascertain that QE really did propel equities higher.
The impact of QE
In a detailed analysis, Deutsche points to two ways in which QE may have impacted stock market movements – by artificially boosting corporate profitability and by raising investors’ animal spirits.
The average return on equity (ROE) among S&P 500 companies is at multi-decade highs; might this elevated level be courtesy of QE? Probably not, says Templeman, who says profit margins have soared as a result of notably diminished competition – changes to anti-trust regulation in the 1980s mean the biggest companies in different industries now enjoy increasingly large market share. This is especially evident in the important technology sector, where high barriers to entry prevent competitors from muscling in on others’ turf.
Profit margins aside, ROE has also been boosted by corporate leverage, which has jumped to multi-decade highs. Bears argue QE resulted in companies levering up with cheap debt and that policy normalisation will force such firms to either delever or accept higher financing costs.
Again, however, Templeman argues these concerns are overblown, with companies having many years to prepare to refinance. Overall, high ROE indicates investors “can have some confidence in the resilience of company fundamentals even as monetary policy is gradually normalised”.
Corporate fundamentals may be sound, but what about seemingly elevated valuations? The TINA effect – There Is No Alternative to stocks in a zero-rate universe – has, bears suggest, driven valuations to lofty levels. The S&P 500’s cyclically-adjusted price-earnings ratio (Cape) has more than doubled since 2009, hitting levels only ever exceeded in 1929 and in 1999 – both prior to major market crashes.
However, Templeman argues Cape is an unsuitable metric for a variety of reasons. Instead, he points to the index’s Q-ratio, which measures the valuation of companies relative to the cost of their underlying assets. The index’s Q-ratio for non-financial companies has risen by only 10 per cent since its 2009 bottom, indicating market gains are largely driven by the growth in underlying business fundamentals rather than by irrational exuberance. The Q-ratio indicates the market value of companies is the same as their asset values – a marked contrast to the late 1990s, when stocks traded 60 per cent above their asset value.
Market distortions
The Deutsche Bank report suggests QE has distorted stock values in some respects, however. Firstly, the rush out of low-yielding assets and into stocks has resulted in investors becoming "less discerning"; firms with inferior fundamentals have enjoyed similar market gains to strong companies. Secondly, the thirst for yield has driven hordes of investors into high-yielding dividend stocks, which are now valued one-quarter higher than the market.
Furthermore, companies have responded to this demand by increasing dividend issuance, in some cases even resorting to debt issuance to fund dividends. The risk is some companies are paying out more than they can afford.
Overall, however, Deutsche Bank’s conclusion is a comforting one for investors. Strong earnings indicate corporate America is strong enough to withstand the withdrawal of QE. Investor preferences may change, and a more discerning approach may result in a “shakeout”, hurting the “not-so-good” companies. Nevertheless, fears the withdrawal of stimulus may trigger a “broad-based equity market meltdown” appear “overdone”.
While the reversal of QE might not appear inherently dangerous, Merrill Lynch’s aforementioned fund manager survey indicates professional investors are wary of the consequences of unexpected policy errors. Markets would prefer that global central bankers follow the lead of the Federal Reserve, which has pledged to stretch out the withdrawal of stimulus and to telegraph its intention to markets well in advance.
Come January, the Fed will have a new chairman, with Donald Trump having chosen to replace the well-regarded Janet Yellen with Jerome Powell. No major changes are expected, and markets were relieved that Powell, regarded as a safe pair of hands and respected across the political spectrum, was chosen ahead of more hawkish contenders like Kevin Warsh and John Taylor.
At the same time, Powell is the first non-economist to hold the job in almost 40 years. Yellen and her predecessor, Ben Bernanke, were both academic heavyweights whose expertise helped guide them through what has been a tumultuous decade in financial markets.
“This is not physics”
Right now, investors are betting that Powell and his fellow central bankers across the world will not make any significant missteps and that stock prices can remain high in the face of gradual policy normalisation. However, Howard Marks warns that the last decade has been one of unprecedented financial experimentation – a world of negative interest rates would have seemed unthinkable not so long ago – and that some caution is warranted.
The old joke that anyone who is not confused doesn’t really understand the situation applies to central banks today, he says. “Anyone who says ‘I am completely confident in my understanding of the situation’, is really not that smart”, says Marks. “This is not physics”. Ultimately, “nobody knows what will happen”.
