The end of quantitative easing (QE) was bound to be messy for financial markets, even if there was abundant evidence of strong growth and rising inflation; but the Fed’s newfound hawkishness comes at a time when inflation remains low and the economic data could still disappoint. If that occurs, market volatility will be even more severe. The unleashing of “infinite” QE helped spur a 12% rise in the S&P 500 forward P/E multiple since last September. Stepping further back, the forward P/E multiple has expanded by almost 40% since real yields dropped into negative territory in 2011, after the Fed began explicitly targeting asset prices. However, with real yields climbing back into positive territory, one of the main supports of the latest leg of the bull market expansion is diminishing.
Valuations should undergo at least a modest squeeze if real yields keep climbing. Higher yields will shift the main support for price-to-earnings (P/E) multiples from liquidity to increased confidence in the longevity of the business/profit cycle. The latter should eventually firm as the economy gains traction, but transitions are rarely seamless, especially in the stock market, and investors should be prepared for ongoing equity volatility, more so in the groups and sectors that have been the prime beneficiaries of low bond yields. Therefore, in the short-term, expect stock, bond and commodity markets to be disappointing.
Fed policymakers appear to be less patient than previously thought. Recently, Chairman Ben Bernanke did not soften his tone on tapering in light of low and falling inflation; instead, he provided some details on the timing of the Fed’s tapering. As long as the economy unfolds as policymakers expect, tapering will be announced in September and completed by mid-2014. Other factors pointing to a hawkish shift in Fed thinking include diminishing economic downside risk, rising home prices, rising borrowing rates as a sign of economic strengthening, better unemployment forecasts, transitory low inflation, and a desire to make the moderation of QE slower by starting it sooner.
The FOMC seems predisposed to decelerating QE even though economic momentum is tepid and inflation is falling because of a change in view on the relative costs and benefits of asset purchases. Policymakers appear more concerned about the possibility of bubbles and rising financial leverage than previously thought. The Chairman suggested that forward guidance has all of the benefits of QE without the inherent risks. On the other hand, by acting against a market that has become too complacent, he is attempting to force out the dangerous and excessive leverage in the system. And while that may feel a little painful right now, we may end up being very thankful that the Committee took the actions it did in the name of preserving future financial stability.
Bernanke’s overriding theme is that everything the Fed does is data dependent. He wants to inject more volatility and a higher risk premia into the market; “It’s important to understand that our policies are economic dependent, and in particular, if financial conditions move in a way that make this economic scenario unlikely, for example, then that would be a reason for us to adjust our policy….our purchases are tied to what happens in the economy. ….we have no deterministic or fixed plan.” Moreover, ending QE is not tightening in the FOMC’s view, since it is the stock of Fed assets that matters in terms of stimulus. Policy will still be highly stimulative even after QE ends, and the Fed will avoid selling assets. This will allow the FOMC to shift its policy focus solely to rate guidance as soon as possible. None-the-less, there remains a fairly high probability that the economic data will disappoint over the summer.
Expect anxious markets in June as we enter the typically volatile summer months. Volatility will create opportunities, but will also add to near term risk. Closed-end fund yields are beginning to look particularly attractive and corporate bankruptcies and defaults are expected to remain low.
Michael Ashley Schulman, CFA