RMG Wealth Mangement’s Stewart Richardson warns of factors that could derail end-of-year rally

Stewart Richardson, chief investment officer at RMG Wealth Management, has highlighted the factors that could undo any expected year-end rally in equities.

US politicians have allowed large swathes of the Federal Government to shut down because they cannot agree a budget for the fiscal year that started on 1st October. Equity markets initially seemed quite relaxed, benefitting perhaps from inflows that are always seen on the first of each month/quarter. However, as the week wore on without any significant progress on the budget, some caution set in and equities backed away a bit – up until Friday that is when hopes of an agreement helped generate an end of week rally.

The budget impasse, however, plays second fiddle to the looming debt ceiling which, according to Treasury officials, will be hit on 17th October. If policymakers do not increase the debt ceiling within the next two weeks or so, then we should expect a serious shakeout in financial markets.

Politics being what it is, we (along with every other pundit) expect a solution to be “crafted” in time for the worst case scenario to be avoided. The solution may not be very elegant, but it should be sufficient to allow financial markets to revert back to normal. So, short term shenanigans around the fiscal impasse aside, what is normal?

If we accept the view that the Fed’s operation twist was a form of QE, the Fed has been continually printing for over two years now and at a rate of US$85 billion per month since last December. QE is now normal. The chart below illustrates the relationship between the Fed’s balance sheet and the S&P 500. As the first phase of balance sheet expansion, QE1 only really gained traction in early 2009 at which time the equity market started to rally strongly. Every time further stimulus has been applied, equities have risen including the period when Operation Twist was in place. In fact, the only period in the last three years that the Fed stopped stimulating (the summer of 2011) the equity market declined.

The summer of 2011 was the last time that Washington had to raise the debt ceiling, and as soon as this was resolved, together with extra stimulus via operation twist, the S&P 500 started to rise rapidly again. With the Fed printing US$85 billion per month, the Bank of Japan now printing the equivalent of US$75 billion per month, and the ECB ready to do “whatever it takes”, then we have to believe that developed market equities will rally into year-end once the fiscal impasse is over.

Although we don’t doubt that equity markets will enjoy a year-end rally, there are two important questions. First, from what level does the rally start, and second, just how sustainable is the rally in the longer-term?

The answer to the first question is that it depends on what happens in Washington. We suspect that the time to buy will be nearer to the middle of the month as politicians seem to thrive on taking important issues down to the wire. The answer to the second question depends on how long the Fed continues with QE and whether the market continues to believe in the efficacy of QE.

Having previously been very comfortable with the idea that the Fed would begin to reduce QE later this year and finish by mid 2014 when they predicted that unemployment would be about 7%, we were (like many in the market) shocked not just by the “no taper” announcement, but by just how dovish Ben Bernanke was in his press conference. Our belief is that the Fed is boxing itself further and further into a corner that will be extremely difficult to get out of. If they announce that they intend to reduce QE, markets may take fright and this worries the Fed. On the other hand, if the Fed just keeps going then at some point (at a time when equity markets are likely to be higher though) the unintended consequences of QE will override the benefits.

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