Could the stock market be headed for a huge fall now that central banks are removing stimulus measures?

Jerome Powell
Fed Chair Jerome Powell speaks in the Rose Garden shortly after his nomination in November, 2017

In the wake of the financial crisis over 10 years ago, the world’s largest economies were left in a precarious situation. Low growth, hampered investor sentiment, lower spending and high unemployment all combined to create an economic malaise which forced central banks to act, in an effort to stimulate the ailing economies which they served.

In the years that followed, the Federal ReserveBank of JapanEuropean Central Bank and Bank of England all took measures to deal with a major economic downturn, which had spread globally.

One way they did this was through quantitative easing, where they bought large amounts of assets from commercial banks and institutions (including government bonds) while raising the supply of money in the economy.

The overall goal was to encourage lending, borrowing and consumer spending and to improve business sentiment, but there was another side effect they were hoping for — an increase in asset prices (including stocks). This side effect was realized, though not only through QE, but also because banks slashed interest rates to historic lows, which meant that bonds became less attractive for investors (due to lower returns). Because of this, investors sought riskier assets like stocks to generate higher returns. With more money being pumped into the stock market, the price of those securities increased. Central banks also hoped that by improving returns from stocks, they could also create a ‘wealth effect’, that would lead to higher spending too.

But that was the past and now all of this is changing.

The Fed in the US and the ECB in Europe are reversing their ‘easy money’ policies, because they think that the US and Eurozone economies are strong enough to stand on their own. It has taken 10 years, but economic markers are now being dubbed healthy enough to begin a long period of ‘unwinding’. The ECB confirmed in a statement on June 14th it would end QE bond purchases by December, while the Fed has already started unwinding its massive balance sheet after ending QE and is raising interest rates as both banks move to ‘normalise’ monetary policy.

What does this mean for investors?

Could things get bad for stock prices now that central banks are removing some support for the economy? Did QE really make that much of a difference to stock market valuations and is broader policy normalisation definitely going to hurt your portfolio? Opinions differ wildly on the matter, which makes things all the more confusing!

Writer Thomas H. Kee Jr. at investment publication MarketWatch said: “We believe that bonds, stocks and real estate will experience significant repricing in the years ahead, with the stock market at greatest risk. A 40% correction in the S&P 500 is possible.” Given the fact that many stocks in that index (particularly big names in the tech sector) look overpriced relative to their peers in other markets around the world, the earlier part of the argument seems like a fair assertion.

Then we have the counter-arguments. A report from Deutsche Bank in late 2017 said that QE may have impacted stock market movements by artificially boosting corporate profitability and by raising investors’ animal spirits, but the overall message was that strong earnings potential for US corporations indicated that corporate America is strong enough to withstand the withdrawal of QE and higher interest rates, and that fears that a withdrawal of stimulus could trigger an equity market meltdown appeared overblown.

Invstr CEO and former Deutsche Bank Director Kerim Derhalli is not so optimistic. He explained: “QE worked by boosting liquidity in the economy as the central banks bought bonds and gave the sellers of those bonds dollars or other cash in return. Many people agree that the liquidity that was generated contributed to the phenomenal rise in financial asset prices. As the Fed continues to unwind its $4.3trn balance sheet, the opposite will be true. The Fed will sell bonds on its balance sheet and drain US dollars out of the economy. This will reduce the liquidity available to purchase equities.”

He added: “Four other factors also bear watching: 1) Interest rates will rise making equities relatively less attractive than bonds. 2) Companies, especially emerging market companies who have added $40trn of debt since the debt crisis (!) will find it much harder to re-finance their bonds and loans in the capital markets. They will be competing for US dollar liquidity with the Federal Reserve. That will lead to more corporate insolvency and create pressure in the equity markets. 3) The US government has massively increased its budget deficit following President Trump’s tax cuts. That means that companies will be competing against both the Fed and the Treasury for liquidity. 4) The consequence of greater competition for dollar liquidity will mean a sharp rise in the value of the US dollar. This will have negative implications for US exporters and commodity producers creating further negative feedback for equity markets.”

Stock markets in the US in particular saw a large correction back in February this year, but relative stability has remained since then. Even with the knowledge that the era of QE and ultra low interest rates is beginning to come to an end, the S&P500 index is still up over 14% since June last year, with a slew of strong corporate earnings for bluechip companies through 2018 thus far too. It seems for most of the year, investors were betting that Jerome Powell and his fellow central bankers across the world would not make any significant missteps and that stock prices could remain high in the face of gradual policy normalisation.

Overall though, as billionaire investor Howard Marks put it to The Irish Times late last year: “We are in uncharted territory with all these central bank policies. We can’t say what will happen.” He added, “Anyone who says ‘I am completely confident in my understanding of the situation’ is really not that smart.”

A smart move for investors would be to keep an eye on this narrative as it develops. Whether the outcome of the withdrawal of stimulus measures is a huge correction in the markets, or whether it’s relatively minor in comparison, the end of the ‘easy money’ era is definitely going to have some impact on global stock indices.

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