The Fed has signalled it may start to taper quantitative easing later this year, sparking fears of a repeat of the market slump that followed a warning of monetary tightening 19 years ago
Investors have grown fearful that the markets could be approaching another 1994-style bloodbath after Ben Bernanke said the Federal Reserve may start to taper its $85bn-a-month quantitative easing programme later in the year.
In 1994, the Fed sparked panic when it used its February monetary policy meeting to warn that it could start to tighten policy and then increased interest rates by a cumulative 300 basis points over the course of the year, prompting falls in bonds and equities.
Last month, Ruffer Investment Company managers Hamish Baillie and Steve Russell warned that the world’s financial markets could be heading towards a similar outcome after Bernanke said the central bank could ease the pace of QE if the US economy continues to improve as expected.
“It is one of the paradoxes that we all need reminding of that any improvement in economic news is likely to mean greater volatility and possibly downright declines in financial assets as investors extrapolate to a period of reduced stimulus from central banks,” the managers said.
“The possibility of a “1994 moment”, where investors lost money simultaneously in both equities and bonds as interest rates rose in response to a brightening economic picture, is, to that extent, a very real concern.”
However, macroeconomic forecasting consultancy Capital Economics argues that the longer-term picture around the 1994 surge in US bond yields and the year’s equity sell-off was more positive than some commentators remember.
Chief US economist Paul Ashworth says: ”It is worth remembering that the 1994 surge did not end in recession but rather was followed by five years of unusually strong economic growth and unprecedented gains in stockmarkets.”
During the 1994, the bond market was hit especially hard. Two-year Treasury yields moved from under 4 per cent in late 1993 to close to 8 per cent by 1994 while 10-year bonds went from 5.5 per cent to 8 per cent. But the economist notes that today’s bond market is unlike to suffer a similar collapse, as the outlook for monetary policy is “completely different”.
Furthermore, the S&P 500 soon recovered from a fall in early 1994 and traded sideways over the course of the year before rising during the dotcom boom. In addition, the impact on the economy was “fleeting”, according to Dales, with the slowing seen in 1995 soon passing to expand at an annualised pace of over 4 per cent by 1996.
Dales also highlights a number of differences between 1994 and today. These include 1994’s high economic growth compared with today’s struggling recovery and a low unemployment rate compared with an above-target one.
“As the Fed has been keen to stress, the eventual withdrawal of policy support and even the phasing out of the current additional stimulus is data dependent,” the economist concludes. “If the Fed thinks that the recent rise in long-term interest rates is threatening the recovery then it will presumably add more stimulus.”
Threadneedle chief investment officer Mark Burgess agrees that the risk of another 1994 scenario is remote as the Fed is not looking to tighten its monetary policy but merely slow it if the economy appears stronger.
“Quantitative easing has been a huge force in driving markets and traditionally the start of a cycle of monetary tightening has been a difficult time for investors,” he says. “However, tapering is only a reduction in the level of the Federal Reserve’s monetary stimulus, not a traditional tightening.”
Threadneedle has been adding to its holdings in US domestic cyclicals, especially in housing-related areas, as its confidence in the country’s recovery is growing. “Better growth, low inflation and still stimulatory monetary policy should be a reasonable background for equity markets,” Burgess adds.
Schroders head of US large cap equities Joanna Shatney downplays the effect of tapering on the US stockmarket, saying that the current pullback should be seen as an buying opportunity.
The manager argues that the next leg of US equity market performance, which she says could begin as early as later this year, will be driven by improved earnings growth rather than newsflow or reliance on ultra-loose monetary policy.
“Higher rates can be complementary to higher equity market returns as long as the rise in economic growth continues. It is generally expected that the Fed will remain accommodative until economic growth and employment hit healthier levels – we subscribe to this view,” Shatney says.
“While the markets are clearly worried that higher rates mean higher discount rates on equities and investments, we are generally more optimistic , choosing instead to focus on the potential for upside surprises that higher overall growth can mean for company earnings.”
BlackRock chief investment strategist Russ Koesterich also says the US economy will be able to withstand a reduction in the pace of Fed’s bond-buying and says the investment case for equities remains strong.
“We would point out that higher levels of market volatility should persist for the coming months, but the case for stocks remains intact,” Koesterich says.
“The basic ingredients of the equity bull market remain intact. Stocks are reasonably priced, interest rates are low, inflation is not a threat and corporate balance sheets remain healthy – all reasons why we believe stock prices should move higher over the intermediate term.”