Kristina Hooper is the US investment strategist and head of US Capital Markets Research & Strategy 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.
The Fed knows that extraordinary times call for extraordinary measures—and the markets just might be unwinding last year’s “tightening tantrum” with a new realization that monetary policy will stay looser for longer.
Stocks finished up again last week, with both the S&P 500 and the Dow Jones Industrial Average hitting record highs. Clearly, the old investment adage “sell in May and go away” didn’t come true this time around—just one of many pieces of conventional wisdom that haven’t proved accurate in this environment.
The reason for this shift? Financial repression—the highly accommodative monetary policy that remains in effect around the world—has changed the investing landscape. For proof, just compare what the Fed has been trying to do with what it’s actually been achieving.
The Fed Is Still In the Driver’s Seat
While the Fed’s stated objectives are to seek full employment in the context of price stability, monetary policy is a blunt tool, not a surgical one. As such, the Fed has had far more of an impact on assets—inflating the prices of stocks and, to a far lesser extent, homes—than it has had on employment.
That’s not to say that Fed policy won’t ultimately have an impact on employment—it already has, and we expect this will continue—but it’s an indirect relationship. Employment is affected by rising household net worth, which in turn improves consumer sentiment and spending, which ultimately results in more jobs created—if all goes according to plan.
But not all is going according to plan in the US economy. That’s because we’re living in a post-crisis environment where companies are still reluctant to spend, choosing to hoard cash rather than hire new employees. Add to that the general uncertainty corporations are feeling about regulation, which only amplifies their instinct to defer spending, and the result is today’s slow and imperfect labor-market recovery.
Yet it is precisely this slow and imperfect labor recovery that is resulting in rates remaining lower for longer.
For the past five years, a highly accommodative monetary policy environment has significantly altered the investing landscape, redefining risk and reward profiles for different asset classes. Many investors don’t seem to realize that this will also hold going forward. Case in point, even though the Fed has begun tapering, it still needs to improve employment, so we don’t expect a hike in the Fed funds rate until the summer of 2015—and even then, it will be a gradual process.
One risk to this scenario is the potential for an abrupt normalization in yields, which last happened in 1994 when the Fed failed to pre-emptively signal its rate hikes and the markets reacted with a monumental correction. As such, investors should watch for any increase in inflation that could trigger such a reaction.
Markets Are Moving Slightly Sideways
Given the backdrop of continued accommodative monetary policy, it wasn’t surprising to have seen the S&P 500 and the Dow hit record highs last week. But it’s also not surprising to see that these benchmarks haven’t made much progress in 2014. In terms of price appreciation alone, the Dow is up less than 1% while the S&P 500 is up a little more than 4%.
In our view, this is more sensible than frothy, given that stock prices have not been outpacing earnings by much. Case in point, earnings of S&P 500 companies grew by only 2.1% in the first quarter. And while valuations may appear stretched when you look at them relative to history, they appear more attractive when viewed in the context of interest rates and inflation.
Furthermore, it is not unusual for equity markets to move sideways once a key economic indicator such as the ISM indices moves past 55. Think of it as the markets taking a mid-cycle pause while the forward-looking sentiment indices wait for confirmation that growth is really happening.
Investors Are Still on the Sidelines
Also in a holding pattern are the many investors who continue to sit on the sidelines, awaiting a correction. For others, the drop in the yield of the 10-year Treasury below 2.5% may be signaling something ominous. After all, conventional wisdom suggests that the bond market is a good predictor of what will happen in the economy, and right now bonds are doing well.
However it’s more likely that this is just one more way that our extraordinary monetary policy has altered the investing landscape and disproved conventional wisdom, at least temporarily. The fall of the 10-year yield this year in many ways is the opposite of the movement of the 10-year yield last year during the taper tantrum. Perhaps this year’s fall in yields is a reaction to the realization that monetary policy will be looser for longer given recent rhetoric from the Fed, just as last year’s move was a reaction to the view that monetary policy would be tighter sooner.
Also consider that with financial repression possibly intensifying in other parts of the world, the 10-year US Treasury actually looks attractive compared to other sovereign bonds such as the German bund, which may be why it has proven popular lately. Other reasons for the US Treasury rally include a technical supply shortage as the Fed continues to purchase Treasuries, a rebalancing of pension funds and heightened geopolitical risk.
The Long-Term Picture for Stocks Is Still Positive
The takeaway for investors is that if they have a long enough time horizon, they should be less concerned about what happens in the short term for the stock market.
In general, this environment is a positive one for stocks, although we expect modest returns this year. Instead, be prepared for more swings. With investors walking on eggshells, we might see an outsized reaction to the May jobs report, coming this Friday, because of what it may mean for what has become the incredibly powerful tool of monetary policy.
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