Markets vulnerable to ‘large correction’ if QE3 flops

Investors are preparing for a sell-off in equities if policy action in the US and Europe fails to be aggressive enough.

The US Federal Reserve provided some hope for investors Friday after saying it would “provide additional policy accommodation as needed to promote a stronger economic recovery.”

An upcoming policy meeting in the middle of the month is being seen as the moment of truth for investors, following on from expected European Central Bank action. ECB president Mario Draghi is expected to announce a bond-buying programme later this week.

However, equity strategists are concerned the US will hold back from expanding its easing programme this month given the uptick in GDP growth, leaving stocks – which are near year highs currently – looking vulnerable.

Trevor Greetham, head of asset allocation at Fidelity Worldwide, said policymakers – particularly in the US – would more likely be forced to act because of a sell-off in risk assets, rather than launching more easing in a pre-emptive move to prevent such a drop.

“We remain concerned markets could retest their lows,” he said. “We would expect policy makers to react to further weakness but so far we have only seen “second best” moves, with the Fed extending Operation Twist and the ECB shaving a quarter of one percent from rates.

“It may take a new sell-off in risk assets and a drop in inflation expectations to shock policymakers into the full-hearted quantitative easing response we think is needed to underpin the recovery.”

US and UK equities have seen some solid gains in the last 12 months, valuations climbing sharply as sentiment improved.

On a year long view, the FTSE 100 is currently at 5,749 points, up 8.7% and just 4% off its high of 5,966 seen in March. Meanwhile the S&P 500 is at 1,406 points, just 1% off its high point of 1,426, having gained 15% in the last year.

Both indices have recovered from the low points seen in October last year – and again this year in May – when eurozone jitters unnerved investors.

European indices have struggled more given the eurozone crisis, but the major markets in the region have held up well, with the German Dax at 6,995 points, not far off the 12 month high of 7,194 set in March.

Frances Hudson, Standard Life Investment’s global thematic strategist, agreed the US was unlikely to stimulate again later this month, with not only stronger growth figures in the US but also the upcoming elections dominating the agenda.

“If it came now, I think it would be a wasted gesture,” said Hudson.

“All eyes are going to be on who is in the White House next year, so I think they will hold back.”

However, if there is no QE, a US-led sell-off seems more likely than not, warn the strategists.

Stewart Richardson, CIO at RMG Wealth Management, said: “It will be a close call as to whether the Fed will announce QE3.

“If they don’t, then markets are vulnerable to a large correction.”

Richardson added that if the US was to launch more QE it would probably deliver only limited upside in markets, given they are near year highs already.

“Between now and 13th September, markets probably remain in limbo, especially as we do not believe the ECB will launch any aggressive policies when they meet on 6th September (although they may continue to lay the groundwork for assisting sovereigns that request help),” he said.

“If they do [act], then markets probably rally a bit more.”

 

This article was fist published on Investment Week

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