Easy on the easing

It is not very controversial to say that it has been a good year for equities. We are seeing the long-awaited moderate economic recovery in the world economy. Over the year until end of October, on a local-currency total return basis, the S&P 500, FTSE All-Share, EuroStoxx 50 and Topix have returned 27.2%, 22.8%, 26.1% and 64.0% respectively.

On 18 December, the Federal Reserve (Fed) decided to decrease the pace of their quantitative easing (QE) program from $85 billion to $75 billion per month. In the Fed’s meeting minutes, released on 8 January, they struck a cautious tone and central banks around the world are currently doing their best to convince us that base rates will stay low for a significant period of time, but the days of unconventional monetary policy could soon be numbered (perhaps with the Japanese quantitative easing programme as the exception).

The equity market reacted favourably to the decision to taper QE and took this as a sign that the Fed now believes that the economic recovery is getting self-sustainable. This is turn spurred a late Christmas rally in equities and the S&P 500 index closed the year over 30% higher than it had been the year before.

However, after a year of exceptionally strong equity returns, many pundits now predict that we are in for a correction in equity markets since QE tapering has finally started. However, recent analysis tells us that the $85 billion of quantitative easing (previous monthly pace of the Federal Reserve’s asset purchases) generated circa £21 billion of share buying. This equates to circa 0.1% of broad US market capitalisation, implying that a complete shutdown of US QE could decrease US share prices by 1.2% over one year.

How about growth? Regression analysis suggest us that 1% higher than expected output entails almost 3% higher than expected returns on US equities, thus implying that 0.4% higher growth would completely offset the effects of an end to unconventional US monetary policy. The result wouldn’t be significantly dissimilar if we investigated the Bank of England’s unconventional monetary policies versus growth.

After a sluggish 2012, the UK’s economy was back with a vengeance last year. Growth increased during each of the first three quarters to an annualised 3.2% in the third quarter, making it the second fastest growing G7 economy after the United States (which grew at an annualised rate of 3.6% over the same period). Economic sentiment and indicators tell us that growth in the fourth quarter remained strong. Meanwhile, risk seems to have receded in the eurozone and the ambitious stimulus programme continues relentlessly in Japan. Strong growth and increasing demand provides an environment where corporate earnings could increase; this could support equity prices. Scrutinising conventional equity price indicators can provide insight as to whether this support has already been priced in.

Normal price/equity ratios currently imply that most developed equity markets, Japanese markets being the exception, are looking increasingly expensive. However, price/earnings ratios have proved to have a very low predictive power and the PE10 (CAPE) ratio, which has historically had a higher predictive power, tells a different story. The PE10 ratio indicates that Japanese and European equities still look attractively priced and UK equities are still cheaper than their long-running average, however US equities look somewhat overvalued.

Finally, if the central banks take away the punch bowl (and the implied equity put) too early, equities will be considered riskier and a correction might take place. However, just because tapering is very much at the table doesn’t mean that the implied equity put is gone. If the pace of tapering frightens equity markets, it can easily be reversed, and central banks can once again let cheap money flow into the system.

Overall the global economic recovery still looks fragile, but as the world where unconventional monetary policy has provided supernormal returns for fixed interest investors is coming to an end, a return to normality means equities still look like good relative value.

Albert Küller is chief economist at Capita Employee Benefits

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