Kristina Hooper, CFP, CAIA, CIMA, ChFC, is US head of investment and client strategies for Allianz Global Investors. She has a B.A. from Wellesley College, a J.D. from Pace Law and an M.B.A. in finance from NYU, where she was a teaching fellow in macroeconomics.
Last week's announcement from the Federal Open Market Committee (FOMC) and the accompanying press conference by Fed chairman Ben Bernanke rocked fixed-income and equity markets alike. Treasury yields rose significantly as prices plunged, and stocks also sold off:
- On Thursday, June 20, the Dow Jones Industrial Average experienced its largest one-day point loss since November 2011.
- The Thursday Dow drop was also the largest one-day percentage falloff (2.3%) since November 2012.
- The S&P 500 Index fell 1.4% on Wednesday and 2.5% on Thursday.
By Friday, however, stocks saw a slight recovery from their intra-day lows. That could be symbolic of a growing recognition that, despite the distinct possibility of Fed tapering, risk assets—particularly stocks—continue to be the most attractive asset class for investors
Tapering Is Toughest on Bonds
While the media have focused on the selloff in stocks, we believe the real story is the impact that tapering will have on fixed income. A tapering-off of—and an eventual end to—quantitative easing (QE) will disproportionately hurt bonds, as we saw when market jitters about tapering began in May:
Taper Talk Hit Stocks Less than Bonds
- The 10-year US Treasury bond price has dropped 9.8% since its most recent high on May 3.
- The 30-year Treasury price has fallen 17.9% since its most recent high, also on May 3.
- Conversely, the S&P 500 is off just 1.4% since May 3—and 4.6% since its last record high on May 21.
Speculation about the end of QE caused stock prices to drop from recent highs—but not as much as Treasuries.
Source: Morningstar, Factset as of 6/21/2013. Past performance is no guarantee of future results.
||June 21 Close
|S&P 500 from record on 5/21
|S&P 500 from 5/3
|10-Year Treasury from 5/3
|30-Year Treasury from 5/3
Stick #1: QE Has Been Pushing Investors into Equities
These numbers are not surprising when you consider that QE is intended to directly manipulate bond prices, whereas it only indirectly impacts stocks.
QE boosts stocks because it makes bonds less attractive and encourages investors to move out on the risk spectrum. The markets have feared QE tapering because it will no longer serve as a stick to push investors into risk assets. In fact, since QE began, the correlation between central-bank asset purchases and stock prices has been 0.89. Yet when the Fed has paused QE in the past, the correlation between asset purchases and stock prices has been very low.
Clearly, when the Fed buys, stocks rise—but the absence of QE doesn’t necessarily hurt stocks. This is especially true when there are other drivers of stock-market performance—and right now there are other sticks and carrots that can drive investors into equities.
Carrot #1: Economic Fundamentals Appear to Be Improving
Despite all the taper talk, the Fed has made it clear that it will not dial down asset purchases unless it is confident that the country’s economic recovery has legs to stand on. With inflation so low right now, the FOMC has the luxury of being able to maintain QE until it is positive that the economy is fundamentally sound and improving. That means stocks may continue their move upward, but it will be driven by economic quality (“EQ”) rather than QE. Indeed, so far this year, the run-up in equities has been due largely to price-to-earnings (P/E) multiple expansion. What we hope to see now is growth in earnings—which will be closely tied to the improvement in economic fundamentals.
Carrot #2: Recent Sell-Off Makes Stocks More Compelling
The selloff last week made stocks more attractive from a valuation perspective—and offered an entry point for investors to start increasing their exposure to equities. The current 12-month forward P/E ratio of the S&P 500 is 13.7, which is below 10-year average forward 12-month P/E ratio of 14.1.
Stick #2: Stocks Are Still the Best Option
Above all, stocks are still the most attractive asset class from a variety of perspectives. Investors last week eschewed stocks, bonds and gold in favor of the presumed safety of cash. But with the yield on the 3-month Treasury bill at 0.05% and the Consumer Price Index at 1.4%, those investors are guaranteeing themselves a negative real yield.
And for those who are enticed by the higher yield on the 10-year Treasury—which at 2.54% as of Friday’s close has now eclipsed the 2.27% dividend yield of the S&P 500—one needs to consider more than yield, although it is important to note that stocks are tax advantaged. Dividend-paying stocks also offer capital appreciation potential while Treasuries carry with them depreciation potential when rates rise and Treasury prices fall.
Yet despite all the good reasons for investors to have adequate exposure to equities, investors continue to be skeptical, as mutual-fund flows for May underscore: Almost $1.5 billion flowed out of US equity funds last month alone.
A New Phase for Equities?
Looking ahead, we expect increased volatility as each economic data point receives a high level of scrutiny because of its potential impact on QE. However we do not believe the start of tapering, whenever that will be, will necessarily result in the beginning of the end for equities. Instead, it could be the beginning of a new phase for stocks—one where the driver is economic fundamentals as opposed to Fed liquidity.
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