Historically, equities have always wobbled around the first Fed rate hike, after a recession. In the process, they have demonstrated a clear setback in prices, while avoiding a bear market. The first rate increase would also normally trigger a bout of sector rotation, with cyclicals and banks underperforming and giving way to the more defensive sectors in the market. Risk assets never like rising rates and draining liquidity, and given the current low levels of interest rates, any tightening will be extended in both duration and extent. Given that most people feel that the markets are currently being driven by easy liquidity, one would expect investors to fear any move to reverse these monetary and liquidity conditions.
However, the bulls argue that the first actual rate hike by the Fed is a long time away, probably not before Q1 2012, so why worry today about an event 12 months away? They feel the party can continue until the Fed actually begins raising rates. Also, given the fact that rates are at zero, even a 25 to 50 basis point hike in rates is unlikely to alter the attractiveness of equities or change interest rate-based valuation models, they argue.
My sense is that instead of waiting for the actual rate hike, markets may start pricing in tightening well before the actual event. Market movements and price patterns may start exhibiting the start of the tightening theme far earlier this time.
Markets are probably just waiting for a change of language from the Fed (extended period and exceptionally low being the key operative phrases) in the publicly released policy statement. Given the extraordinary nature of monetary easing in this cycle, a change of language will signal the intention of the central bank to move back to more conventional policy settings. Also, historically, central banks were far less communicative, with regular Federal Open Market Committee commentary only beginning in 1999. With the change in approach towards communication, the policy statement has a clear signalling effect. Given the type of hawkish statements being made recently by certain Fed governors, a change in tone from the Fed is imminent.
There is also a growing feeling that we are approaching the end of this phase of quantitative easing (QE). QE2, as it was called, is likely to be wound down by June, with the completion of the Fed’s buying programme of $600 billion worth of treasuries. Though there is still hope on the part of investors that this programme will get extended, the politics of Washington would seem to indicate that any extension is unlikely. The decent employment report released last week and the strength in markets make the case for extension weak. Recent comments by the Fed also indicate debate and disagreement, with some members even arguing for an accelerated tightening programme. The formal winding down of the QE2 programme will be definitely taken by the markets to signal the end of extraordinary easing and opening the doors to the start of policy normalisation. The Fed will have to shrink its balance sheet, and any steps taken to do so cannot be good for risk assets.
At the same time as the Fed is likely to wind down QE2, we have the European Central Bank (ECB) embarking on a tightening agenda. Most market observers expect the ECB to hike this week itself, despite the clear difficulties being currently faced by the peripheral European economies. The ECB seems to prefer targeting incipient inflationary pressures, rather than trying to ease the economic pressures on the highly indebted periphery. In the next couple of months, the Bank of England will also move to tighten. Thus, by June we will have all the major developed world central banks (except Japan) either tightening or, at the least, no longer injecting liquidity into the system.
Combine this with the fact that all major emerging market central banks in China, India, Brazil, Turkey and Russia are also implementing some form of quantitative tightening if not outright interest rate increases, and the outlook for equities and risk assets should be challenged. Most of the emerging market central banks including India are still in the midst of their tightening cycle, with still some way to go.
Going by the recent past , markets will wobble, once some of the extraordinary stimulus measures are wound down. If we look at the last two years , global equity markets bottomed in March 2009, as the US began QE1(buying treasuries, agency bonds and mortgage-backed securities). Markets began to struggle in April 2010, once this buying ended and then picked up again with the announcement of QE2 in August 2010. Logically, markets should struggle once again, now that we are about to complete the latest and probably the last bout of Fed asset buying.
Markets, however, do not seem to be perturbed at the moment. Maybe market participants feel that given all the headwinds around global growth in terms of debt burdens, housing market weakness and unemployment, we will not see an extended period of tightening. However, it is difficult to envisage any tightening without interest rates rising significantly, given the current levels.
The headwinds for global equities continue to build. We have the tightening of liquidity discussed above, oil prices at $120 and rising, sovereign issues and surging commodity prices. Yet, markets continue to rise. Whether it is the yen carry trade being put back on, or investors trying to time their exit from markets to perfection, risk appetite remains strong. This seems unlikely to last. The Australian dollar, Brazilian real, gold, silver and soft commodities all are in a strong uptrend. The Russell 2000 index of small cap stocks is at an all-time high, even crossing its 2007 peak. All the money pumped in by the Bank of Japan seems to be finding its way to all sorts of financial assets. Though this cannot continue indefinitely, it is very difficult to predict how much steam markets have left. It is prudent to remain cautious and not chase momentum.
India has done extraordinarily well over the past two weeks, with markets rising by more than 10 per cent from the bottom. The Indian markets also seem to be caught up in this momentum trade, with markets going up despite oil prices, inflation and other domestic issues. India is not cheap, and earnings are going to be at risk. What the upside is from here in the short term is debatable.
The author is fund manager and chief executive officer of Amansa Capital
