The idea of a Federal Reserve (Fed) that ‘has the market’s back’ is not a new phenomenon; the origins go back thirty years to the Alan Greenspan era. In the aftermath of the 1987 stock market crash, the Fed Funds rate was lowered, injecting liquidity and restoring confidence to the financial system via equities. Similar responses were implemented during the Gulf War, Asian and Russian crises of the late 1990s, the unwinding of the technology bubble and the 9/11 terrorist attacks. This phenomenon became known as the ‘Greenspan put’.
But the concept really came into its own in the aftermath of the 2008 global financial crisis, when the Fed lowered short-term interest rates, as well as targeting longer-term rates via quantitative easing. The result was that the equity risk premium (ERP) soared to nearly 7% by the end of September 2011. ERP measures how much more (earnings) yield investors are effectively receiving from equities than from government bonds. Today’s ERP stands at 3.2%, a still-attractive premium for equity investors that has given rise to another acronym – TINA, or ‘There Is No Alternative’.
Given that government bonds have produced weak returns since the early 2000s and the ERP has been higher than average since 1990, equities have been the more attractive option for many investors for some time.
High ERP means TINA
Many market participants have never known an environment in which the ERP is below its long-term average. But remember that acronyms and descriptors such as TINA and the Greenspan Put are observations rather law. Things can and do change.
Today, the current risk to the positive ERP is the Fed itself. Until very recently, it confirmed the Greenspan put on a regular basis, backing away from raising interest rates at the slightest excuse. But something changed towards the end of last year, with the Fed’s tone becoming more hawkish.
Responding to weaker economic data in the first quarter of 2017, the central bank stated that it “views the slowing in growth during the first quarter as likely to be transitory.” This implies that the Fed is prepared to bet on a stronger economy in the future, even in the absence of supporting evidence today.
Work aplenty but pay rises elusive
Understanding why the Fed has become more determined to tighten policy is important, since it could inform future asset allocation decisions. Psychologically, there is a compelling temptation to declare victory and normalise monetary policy; The Fed chairperson who can state ‘Mission Accomplished’ will doubtless secure their place in history. But fundamentally, it may simply be that the Fed no longer needs to support the equity market in the way that it did in the 1990s and immediate post-crisis period. We know that US retail investor participation in equities is not what it used to be – the tech bubble unwind and 2008 saw to that. Furthermore, the relationship between the stock market and retail spending appears to have broken down. The post-crisis period saw the US equity market soar while retail sales flatlined, suggesting that what happened in the equity market was not affecting consumer sentiment anymore.
The Fed has noted these profound secular changes, with the result that it is more likely to tolerate volatility in equity markets than has been the case historically. It stated that it believes the market to be expensive. That doesn’t mean it wants to engineer a market correction, but it is less likely to to stop one.
Market up, retail sales flat. Market down, retail sales…likely flat.
US equities have been trading in a tight range for some time now, with very few days seeing greater than 1% drawdowns since late 2016. While there is nothing on the horizon to suggest a major crack in the market, the Fed’s willingness to normalise policy come what may could change the situation. In turn, the central bank is unlikely to seek to limit any market falls. This suggests investors seek out option protection while equity markets remain buoyant. For multi-asset investors, it may also be time to start banking the sizeable gains made in equities in recent years and begin rotating into low duration bonds where income represents a lower, but more reliable return. The majority of today’s investors have known nothing but an equity market with implicit central bank protection included. But it was never a lifetime guarantee; this Fed is in no mood to look out for an equity market that it sees as expensive and disconnected from both the real economy and consumers. Investors are on their own.