Stewart Richardson, chief investment officer at RMG Wealth Management, has highlighted the factors that could undo any expected year-end rally in equities.
Will the Fed reduce QE in 2014? Well, that depends on who is in charge from the end of January. If it is Janet Yellen, there is a possibility that she is even more dovish than Ben Bernanke, and QE will not be reduced for a long time. Now let’s throw in a bit of a curve ball. What happens if Janet Yellen is not the next Fed governor? It has been three weeks since Larry Summers withdrew from the race, and Obama has still not nominated Yellen. Why not? Obama keeps talking about the need for a Fed that does not create asset bubbles and it seems that he is extremely concerned about rising income inequality. Is Obama still searching for a candidate other than Yellen who will focus on income redistribution rather than asset price manipulation? That would be a shock to equity markets and would probably stop a year-end rally dead in its tracks.
The chart below shows the share of income in the US going to the top 1% of earners. Whether capital gains are included or not, the massage is the same; the top 1% are taking an ever increasing share of the nation’s overall income, and sits at a post WWII high. It appears that the administration are beginning to recognise this rising inequality and more importantly want to do something to reverse it.
We have previously made the case that the Fed’s bond buying has a natural limit because at some point they will own too much of the Government bond market for it to function properly. Furthermore, when they buy US Treasuries, the Fed effectively removes high quality collateral from the repo market, which could cause problems in the event of a market seizure.
So, our belief remains that the Fed has to reduce QE at some point, either because they risk disrupting markets through their sheer size, or because of political pressure. That said, the day of reckoning could be pushed out much further than we thought possible just a month ago. Of course, the Fed could choose to reduce QE at a time of their own choosing, but will risk the markets selling off as they tighten policy.
So, our near term view is that a year-end rally is likely once the fiscal impasse is overcome. The Fed and the Bank of Japan are printing like crazy and the ECB stands ready to do whatever it takes, and this combination alone should be enough to lift asset prices. Most equity markets should rise, core Government bond markets are likely to struggle and the US Dollar should remain under pressure. This party will end at some point, but probably not before year-end unless there is a strong signal that the Fed is ready to start reducing QE.