Will the Fed end the stock market rally?

DESPITE several major challenges and uncertainties associated with the Covid-19 pandemic, US and global stock markets have staged a phenomenal rally of more than 90 per cent over the past 18 months.

The US Federal Reserve has played a key role in helping markets to climb a wall of worry through its ultra-loose monetary policy, which has seen the US central bank double the size of its balance sheet to more than US$8 trillion now, compared to about US$4 trillion before the Covid-19 outbreak.

This means that the Fed injected more than US$4 trillion into the US financial system over the past one and a half years. Along with this, US bond yields fell sharply, and real interest rates fell deeper into negative territory, making cash an unattractive investment option and allowing investors to turn to leverage at very low cost. All these helped to fuel the massive equities rally.

However, now, markets are concerned that the Fed could upset the apple cart and bring an end to the stock market rally after it signalled imminent tapering recently following its September policy meeting.

Currently, the Fed is injecting US$120 billion of liquidity into the financial system each month by buying US Treasuries and mortgage-backed securities. This was done because the US economy was in a recession last year due to Covid-19. But now, the US economy is no longer in a recession and is improving.

The Fed has signalled that it is getting ready to reduce its purchase of bonds until it stops buying them altogether. This process is called tapering, and it can take several months to complete. Previously, from 2013 to 2014 when the Fed tapered, the process took place over 10 months.

This time around, our guess is that the Fed will start tapering in November this year and continue tapering for eight months until mid-2022 at a rate of about US$15 billion each month.

We do not think that Fed tapering will derail stock markets and cause them to plunge.

The Fed has learnt its lesson when it last tapered from 2013 to 2014 and initially caused a taper tantrum and a 6 per cent fall in the S&P 500 index. So, it has been communicating its intentions and preparing the markets for several months now to avoid surprises. Consequently, when tapering takes place, it should not cause any major market disruptions.

Also, remember that the Fed is tapering and not tightening. Plus, the US economy is still facing challenges from the Covid-19 Delta variant, and because of this, we think that the Fed will move cautiously, which should be good news for equities.

From 2013 to 2014 when the Fed tapered, the US stock markets did not collapse. It was very volatile though, but still managed to post a 44 per cent gain over the two-year period. Global equities also did quite well during the period, rising by 28 per cent.

NOT THE ONSET OF A BEAR MARKET

In the 2013 taper tantrum episode, investors learnt that the Fed planned to taper when Ben Bernanke, the central bank's chairman then, stated in a congressional testimony on May 22 that the Fed would reduce the size of its bond buying programme. Bond markets were roiled, and US 10-year government bond yields rose sharply from a low of about 1.6 per cent that year to 3 per cent by year-end. Despite this, US stocks did well and still rose by 26 per cent in 2013 while global equities were up by 22 per cent.

Looking back at the 2013 episode, talk of Fed tapering started making its way into the markets at the start of that year. However, the Fed only started tapering in January 2014 and ended tapering in October 2014.

With the economic recovery gaining traction through 2014 and with investors maintaining a healthy appetite for risk, the process of tapering did not derail stock markets; they still performed well. This time around, as economies gradually re-open, recovery should gather momentum, which should be good news for stock markets.

The bottom line is that after the strong stock market rally of more than 90 per cent in the past 18 months, valuations have become less attractive, but they are not yet excessive as real interest rates are still very low by historical standards, and there is still a lot of liquidity on the sidelines.

Also, the economic and earnings outlook is improving, and fiscal and monetary policy will remain accommodative given the uncertainties with Covid-19.

All these should augur well for equities, and we remain sanguine on the asset class for the medium term. So, it makes sense to stay invested but it is important to invest carefully.

Intermittent market pullbacks will take place and they are normal after a strong rally. Remember that these pullbacks represent corrections and not the onset of a bear market.

So, pullbacks can offer buying opportunities for those with a good risk appetite. However, do tread carefully, buy selectively, and buy gradually as markets are likely to be choppy in the coming months as investors await the official start of Fed tapering.

• The writer is executive director, investment strategy, at OCBC Bank.