The job of the Federal Reserve is “to take away the punchbowl just as the party gets going” – William McChesney Martin
We have been pretty relaxed about the rise in stock prices so far. Short-term charts look stretched, and some pull back is overdue, but valuations look unremarkable, and the primary trend is still positive. If we sell out now we may miss a resumed rally.
We suggested last week that the disconnect between the global economy and stock prices is not as big as many fear. Much of the rally since March 2009 has simply reflected a rebound from the over-correction of the credit-related excesses of the last cycle, and the market is not so much leaping ahead of the economy as catching up with it. Economic growth has been mediocre for sure, but the pre-crisis highs in global and US GDP were regained in 2009 and 2011. Meanwhile, profits have broadly kept pace with the markets, keeping a lid on valuations (like stock prices, they over-corrected, on account of huge financial write downs).
At some stage, we will need to push this logic a little further. The slowing in US growth in the second quarter is likely to be transient, and the need for drastic fiscal retrenchment further down the road is being muted by the tumbling government deficit. Even the UK’s feeble recovery got some moral support this week from the outgoing governor of the Bank of England, not noted for his optimism. If the two big consumer-driven western economies are indeed slowly becoming capable of standing on their own two feet, eventually they’ll be asked to do so. The central banks will begin to take the punchbowl away: quantitative easing (QE) will slow, cease and eventually reverse, and interest rates will begin to normalise – and not necessarily in this order.
Although QE and low rates are not quite the economic life support system that many think, investors may fear the loss of the stimulus as it begins to be switched off. If so, the current parallels with the mid-1990s – a reversal in emerging market and commodities performance, and a stronger dollar – will become even more striking: 1994 saw a big setback for bonds and stocks when the Fed tightened after a long period (by the standards of the day) of lenience.
Even such a policy-driven sell-off need not terminate that positive primary trend in stock prices: to extend the party analogy, you can have a decent time sober. When the dust settles, a self-sufficient recovery will likely be seen as a good thing for risk assets (as it was in 1995, and, after less volatility, when rates started to rise in 2004). That said, given current belief in QE, the correction would probably be big enough to be worth trying to avoid tactically: it is the most obvious pothole that we think lies ahead on the long road to capital market rehabilitation. For now, any normalisation of the monetary climate still lurks over the edge of the forecasting horizon – but surely nowhere near as far as it did in 1943, when (we feel compelled to note in this history-conscious climate) the official UK interest rate had also been on hold for four years and was about to stay put for a further eight.
Kevin Gardiner, Chief Investment Officer, Europe