News that the Federal Reserve may start to taper its $85bn-a-month quantitative easing programme later this year has sparked a sell-off across the markets and left investors fearful of another 1994-style bloodbath.
The Fed ushered in panic in 1994 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.
Earlier this month, Ruffer Investment Company managers Hamish Baillie and Steve Russell warned that the world’s financial markets may be heading towards a similar outcome after Fed chairman Ben Bernanke said the central bank could withdraw stimulus.
“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,” the managers say.
However, macroeconomic forecasting consultancy Capital Economics has pointed out that the longer-term picture around the 1994 bond and equity sell-off was more positive than some commentators remember.
Chief US economist Paul Ashworth says: ”It is worth remembering that the 1994 surge [in Treasury yields] 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 late 1994 while 10-year bonds went from 5.5 per cent to 8 per cent.
But 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 Ashworth, with the slowing growth seen in 1995 soon passing to reach an annualised pace of over 4 per cent by 1996.
Ashworth 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.”
BlackRock chief investment strategist Russ Koesterich believes that 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.”
Schroders head of US large-cap equities Joanna Shatney also downplays the effect of tapering on the US stockmarket, saying that the current pullback should be seen as an opportunity.
The manager argues that the next leg of US equity market performance, which 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.”