Fed inaction greases path for equities and other risky assets
Gorge on Halloween candy, Thanksgiving turkey and risk: the Fed has declared an early and extended holiday.
The US Federal Reserve left policy unchanged at its meeting on Wednesday, maintaining its US$85 billion per month schedule of bond buying and making only a few changes to the accompanying statement.
The Fed said it wanted to see more data before making any changes to policy while noting that the recovery in housing has slowed and inflation remains below target.
With no meeting until December and little sign of an economic resurgence in the wake of the government shutdown, it is looking like investors will not face a “taper” of the Fed’s bond buying programme until next year, possibly at the March meeting at which Janet Yellen will make her debut as chairman.
The upshot, for good or ill, is that equities and other risky assets have a clear and greased path between now and the end of the year. That, of course, is exactly how people have been behaving.
Despite rather tepid US corporate earnings this season and some evidence that consumers pulled in their horns during and after the government shutdown, major stock market indices are at nominal all-time highs.
You might call this a cynical rally, but it is a real one, with real money changing hands. And remember, the old adage “don’t fight the Fed” is arguably more true now than it has ever been.
Stephen Jen at hedge fund SLJ Macro Partners has done research showing that the Fed is three times more powerful in driving equity markets over the past decade compared with 1980-2002. SLJ research shows that Fed actions now account for 40 per cent of equity market variations, compared with just 15 per cent from corporate earnings.
“In sum, if the US economy remains lukewarm in the remainder of the year, it is likely that we see the following: higher equity prices, lower bond yields and a relatively stable dollar, i.e., a dollar that will struggle to go lower, despite a dovish Fed,” Jen and colleague Fatih Yilmaz wrote in a note to clients.
To be sure, there is always the possibility that the Fed surprises with a December or January taper, or that there is some testimony from Yellen at her congressional approval hearings that ups taper expectations, but the stars would have to go some way to come into alignment for that to happen.
Indeed, in some ways, the scariest thing is the extent to which this is all baked into everyone’s expectations. Even if a stock market rally into year-end is the most likely outcome, the sheer power of everyone having the same expectations and trying to fit through the same door raises the costs if expectations are not met.
In the past few days, there have been multiple data points indicating how aligned most investors are.
Options markets demonstrate that most investors are positioned for gains, with some measures of investor optimism at near year highs.
Pessimism in the AAII Sentiment Survey of individual investors fell to a 21-month low, and optimism rose to a 10-month high. The proportion of investment newsletters that are bearish measured by Investors Intelligence is as low as it has been since 2011 and is in territory touched only four times in the past decades.
So, what are the risks?
Probably there are only marginal ones between now and the end of the year. US politics will simmer but will not become a focus until next year.
Europe and Japan are, if anything, more likely to be sources of positive news than negative shocks. There are no other geopolitical issues on the immediate horizon that would unduly upset markets.
And of course, there is the fact that an up year in markets may force the hands of whoever has been underweight risk. Self-preservation is a powerful incentive, and presenting a bearish portfolio in year-end investor letters is not going to be popular this year.
In some ways, the biggest risk may simply be a period of quiet in which investors can begin to puzzle out why exactly they are so optimistic about the stream of future earnings their stocks represent.
While this earnings period has been fine, again we have seen better performance on earnings than on revenues. Bottom-line growth cannot outpace top-line growth forever.
And the Fed may well want to send a message, after the confirmation hearings of Yellen, that the taper cannot be put off forever.
When the taper comes, the biggest factor in equity markets will be pushing down not up. That implies considerable losses.
When that happens, the holiday bills will come due.