by Raul Elizalde - 2013-06-21
Fed Chairman Ben Bernanke hosted a highly anticipated press conference on Wednesday where he gave the Fed’s official view on the economy, inflation, and monetary policy. The three take-away points were that the Fed sees the economy on a modest but solid path to recovery, that inflation forecasts are going down, and that at some point within the next 18 months, give or take, the Fed will end its ultra-aggressive monetary policy if it believes that the economy can stand on its own two feet.
The market reaction to all this was starkly negative, and in all likelihood took the Chairman by surprise. Bond rates shot up, mortgage back securities (which the Fed has been buying at a rate of $85bn per month) tanked, and US stocks had the largest two-day decline in over seven months. Foreign stocks and commodities plunged.
Why did the market react so poorly?
Since everyone knew that the Fed would eventually have to taper down its asset purchases, announcing that it could happen within the next year or two could not have been a major surprise. What was different was that the Fed put aside its usual vagueness and provided the market with a timetable. Never mind that Bernanke insisted that the timetable was highly contingent on permissible conditions. The prospect of not being able to rely on the Fed’s training wheels turned out to be terrifying. Wall Street, the ultimate free-market capitalist arena, seemed too scared of being set free.
It is said that markets like certainty. One could have argued that the Fed’s announcement – a more precise delineation of the future – meant more certainty, not less, and therefore should have been a positive. But, having operated under explicit central bank support for the last four or five years, some no longer trust an “invisible hand” to provide order. After all, a free market can be a destroyer of wealth, like in 2008. What the market heard was that it would be pushed into the unknown.
Other factors added to the general fear. That same day, for example, the Chinese central bank refused to inject liquidity into its cash-strapped banking system. Short-term rates shot up, and despite the clamor, the People’s Bank of China kept tight monetary conditions in place. Analysts bemoaned the withdrawal of money at a time when China’s growth is decelerating. But the PBOC’s actions may prove to be wise.
Aware that the explosion of credit brought Western economies down to their knees in 2008, the Chinese are worried about their own credit expansion – especially in the off-balance-sheet system known as “shadow lending” that operates under the radar of monetary authorities. The PBOC squeeze may be aimed at flushing out system weaknesses before they become too dangerous. While indeed this may cut growth at a time when the global economy is sluggish, it may also help defuse vulnerabilities that can be nastily exposed in the future.
But all the market appears to see is another central bank ready to end the unconditional flow of easy money. At the moment, this is not a welcome sight.
The rush to cash in created other problems as well. An end to central bank easing makes it clear that, barring an unforeseen turn towards deflation, interest rates are going nowhere but up. Since the markets always move in anticipation to events, interest rates spiked immediately. Bond prices (which move in the opposite direction of interest rates) plummeted.
Bond funds had already been under pressure for the last few weeks, suffering record outflows. Bond ETFs, in particular, were badly hit. Given the absence of buyers, some bond ETFs traded briefly at significant discounts to the value of their underlying holdings. The upheaval in the bond market only added to the overall agitation.
So what does the future hold?
In the long-term it is far from clear that stocks are poised for another 10-fold secular increase like in 1982-2000 or 1949-1966 (see graph). Given the many uncertainties faced by the world today (a bogged-down Europe, political turmoil in emerging markets, and the rise of China) it seems reasonable to expect that risk assets may not be ready to embark in a massive uptrend.
But, despite long-term uncertainties, the downside for stocks may be limited. As we argued in our last newsletter (6.3.2013 - The bull market may not be over yet), the S&P500 can drop to the low-1500s from today’s 1590 without changing what is essentially a bull market condition.
One of the reasons is that money is pouring out of bonds and needs to be invested, which is a positive for US stocks as long as economic activity remains healthy. With private-sector GDP growing at around 3.5% and corporate earnings hovering at record highs, the US economy does not seem to pose significant threats to stocks. As long as the declining inflation outlook does not rekindle fears of deflation, the recent market swings may just prove to be consistent with the mean-reverting nature of volatility.
Still, the next few months may prove to be frustrating, as summer has a history of being unpredictable and the fall months are notoriously tricky. Investors may opt for cashing in their still sizable year-to-date market gains. The Fed spoke and the market threw a tantrum. It may now need to rest a while to regain its cool.
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