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Inflation is at its highest level in decades. The US Federal Reserve (the “Fed”) is embarking on one of the most brutal cycles of monetary tightening in its history. War is raging in Eastern Europe. Oil is running at well over USD 100 per barrel. And yet equity markets are surprising calm, particularly in the US. The S&P 500 is just 5.5% off the historic highs reached at the end of December, having bounced by over 8% in less than two weeks. “Irrational exuberance” or a sign that, little by little, investors are adjusting to the new monetary environment without any radical shift in their positioning?
Based on recent history, it is tempting to assume the latter and believe in a continuation of the rally. Indeed, in previous periods of monetary tightening, markets have tended to perform very well, particularly in the early stages of tightening. The S&P 500 rose by 33% in the 18 months following the first rates hike in the 1988 cycle of tightening, by 19% in the 1994 cycle, 10% in that of 2004 and 17% in that of 2015.
But earlier periods paint a less rosy picture. Positive performance in the equity markets was hardly a feature of periods of monetary tightening during the seventies and early eighties, but this was more due to the oil shocks and their economic consequences than to monetary policy alone. The period of tightening during 1986-1987 is a more interesting case. It ended with the crash of October 1987 and Black Monday, which saw indices drop by close to 30% in a matter of days, exacerbated by a technical phenomenon related to portfolio insurance strategies. This environment has some similarities with today’s situation: sound economic growth, high inflation, rising interest rates followed by a hike in central bank intervention rates, and lastly, an equity market bubble with high valuations after a strong bull rally.
And today’s situation is, in many respects, very different to the pain-free cycles of monetary tightening in recent decades. Inflation is at its highest level for 40 years, although at a more modest level than the highs seen in summer 2021; the S&P 500 is still 20% above its long-term median and its average level prior to the previous three cycles of monetary tightening; and the Fed is set to introduce an unprecedented cycle of tightening. To date, monetary tightening has consisted primarily of a series of key rates rises, at a quicker or slower pace. But since the 2008 crisis and the broad extent of quantitative easing measures (i.e. asset purchase programmes) introduced, cycles of monetary cycling now also include measures to reduce central bank balance sheets. Firstly, by putting an end to asset purchase programmes and subsequently by reducing the size of central bank balance sheets by not reinvesting amounts arriving at maturity, i.e. in theory, by net asset sales. Highly dependent on the abundant liquidity offered by these quantitative easing programmes, markets are thus all the more vulnerable when they disappear.
Seen in these terms, there is a question mark over the current strength of equity markets, particularly in the US. In our view, extreme caution is called for, even if the most overvalued stocks have already partially corrected. The old stock exchange adage, “Don’t fight the Fed”, has proven extremely relevant in recent years and investors would do well to remember this.
Written on 25 March 2022 – Olivier de Berranger, CIO, LFDE