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Deutsche Bank strategist nails S&P 500 with Fed theory

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THERE is one sell-side analyst who managed to predict last year's volatile markets, and he does not come with a wizard nickname in recognition of his prognosticative skills.

Washington

THERE is one sell-side analyst who managed to predict last year's volatile markets, and he does not come with a wizard nickname in recognition of his prognosticative skills.

Deutsche Bank strategist Aleksandar Kocic wrote earlier last year that the S&P 500 Index could hit a floor of between 2,300 and 2,400 as the Federal Reserve normalises monetary policy. The benchmark equity index reached 2,351 on Dec 24 and has since rallied 6.5 per cent to about 2,500.

His prediction stands in stark contrast to many others on Wall Street in a year characterised by intense swings. As 2017 drew to a close, the median target for the S&P 500 at the end of 2018 stood at 2,855, according to a Bloomberg tally. Even Marko Kolanovic - the JPMorgan Chase strategist dubbed "Gandalf" - predicted only a modest uptick in volatility for the year.

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How did Mr Kocic nail the move in a year that saw many other professional forecasters founder as worries over economic growth, trade tensions and political gridlock whiplashed equities? With a relatively simple theory about the Fed's impact on markets and the notion that the central bank "put" which has backstopped risk-taking is now being repriced.

"Despite all the political entropy, our view has been that the market is simply misreading the outdated and unreliable signals and making incorrect conclusions about the economy, and using that information to scale down on risk," Mr Kocic wrote in a Dec 27 e-mail to clients seen by Bloomberg. "Although the equities whipsaw continues around the Fed put, the strike around 2,300 (as we predicted in Feb and reiterated in October) seems to be doing all right."

Mr Kocic contends that years of quantitative easing after the financial crisis effectively saw the central bank suck systemic risk out of the market, forcing the beta - or co-movement - between equities and short-term interest rates to move higher as the Fed provided a backstop for risk and encouraged investors to snap up financial assets.

As the Fed withdraws its extraordinary policy and unwinds its balance sheet, the beta between equities and interest rates begins to normalise. Based on Mr Kocic's calculations, the "normal" beta between equities and yields during a Fed hiking cycle should be closer to 10 - implying a 2,300 to 2,400 level on the S&P 500 - versus the 30 beta seen earlier this year.

Mr Kocic's theory could have implications for the central bank as it tries to pare back monetary stimulus without overly roiling the markets. After 2008, the Fed became an emergency supplier of "convexity" - or downside protection - after the market mispriced risk in assets such as "conventional callables, mortgages, credit, CDS and structured products". Mr Kocic argued earlier last month that the central bank is currently shedding its role as "convexity supplier of last resort" in favour of managing convexity instead.

Still, the Fed has to carefully reintroduce risk into the system as it tightens financial conditions and be in "constant communication" with markets, he said, at a time when some investors have criticised it for raising rates.

Mohamed El-Erian, Allianz's chief economic adviser, said in an interview last Sunday that the central bank needs to "show that it is more sensitive to markets and what's happening outside". WP