OCEAN CITY — The Federal Reserve (Fed) is set to end its historic bond purchasing program this month, making the divergence of monetary policies globally ever more apparent. As the U.S. faces the end of an era, Europe and Japan, as well as several emerging markets, are in the throes of monetary easing. Despite a calm ride for the majority of this year, we still see the potential for volatility to pick up in the months ahead, as the Fed navigates normalization of interest rates in a choppy economy.
Last week, two years after beginning Quantitative Easing, the Fed announced the program’s last round of bond purchases. Although Chairwoman Janet Yellen pledged to keep interest rates near zero for a “considerable” period, the unprecedented monetary policy accommodation of the past six years is gradually coming to an end.
According to BofAML Global Research, unless consumer and business spending meaningfully increase and inflation picks up, further easing is likely. As it stands, the central bank’s balance sheet is already more than half of the country’s GDP.
Accommodative monetary policy has not been limited to developed markets. Nine out of the 16 inflation-targeting Emerging Market countries have cut interest rates this year, according to BofAML Global Research.
While the global economic recovery has been tepid at best, the U.S. has been an outperformer. Industrial production is near multiyear highs, retail sales growth has been stronger than expected and business investment is finally picking up. Contrary to the situation in Europe and Japan, inflation has risen this year, even with the weak consumer price index numbers last week. Labor
markets have also improved, although a soft August employment report confirmed that pockets of slack remain.
Global economic growth has seemed a roller coaster ride this year, but one would never know it from where the markets stand today. With only a few minor dips, global equities are up more than 6% year-to-date. Bonds have also gained, despite fears that last summer’s “taper tantrum” would repeat itself. The dollar is stronger against most of its peers, reflecting faster growth in the U.S.
In this new regime of lower liquidity and higher growth, our base case remains that equities will outperform bonds. The equity risk premium, a gauge of expected returns for equities relative to bonds, remains slightly above its historic average.
To upset the apple cart, the economy would need to really take off, spurring inflation concerns and forcing the Fed to accelerate its rate hikes. That happened 20 years ago, in 1994, when the central bank surprised the markets by raising short-term rates, causing volatility to spike and both equities and bonds to sell off.
The Fed thus faces a formidable communication challenge as it moves to normalize policy. The S&P 500 already sits above BofAML Global Research’s year-end target. With the final month of QE ahead, and the fall historically a weak period for equities, volatility may pick up. BofAML Strategist Savita Subramanian notes that although sentiment and fundamentals remain supportive, stocks could face some near-term pressure, so the focus should be on picking the right spots. (A Merrill Lynch Wealth Management Advisor who can be reached at 410-213-8520.)