- Markets must now learn to cope with less support from Fed.
- I believe investors will adjust to the higher confidence regarding sustainable growth and the risk premium will fall more than the slow rise in rates.
- Equity markets will likely recover, but expect some stumbles along the way.
Awww! The equity market is learning to stand on its own without the Federal Reserve holding its hand. There will be moments when it ends up on its bottom but the good news is a baby doesn’t have much momentum and doesn’t have far to fall. Also, Uncle Ben will continue to make sure there is a soft security blanket to fall on.
As many of you are aware, we have argued the market price earnings multiple is an amalgam of many factors. However, two of the most important are the perceived sustainable growth rate in the economy and the risk of inflation or deflation. Uncertainty over these areas has held back the equity multiple despite record low Treasury yields. The market discount rate is an aggregation of those rates plus the risk premium. The Fed was telling us it was undertaking extraordinary monetary policy to stave off lower growth and the risk of deflation. Consequently, while rates fell risk premia rose. As the Fed begins the long path to “normal” monetary policy the market must make adjustments.
As my colleagues in this week’s Perspectives point out, the Fed appears more confident about the future. Initially, the focus is on the “gradually rising trend” in rates causing the market to correct. However, I believe investors will adjust to the higher confidence regarding sustainable growth and the risk premium will fall more than the slow rise in rates allowing the equity market to recover. There should also be a change in market leadership from defensives to economically sensitive sectors.
Just like a baby’s first steps on two uncoordinated wobbly legs, the market’s adjustment to the movement in rates in one direction and the movement in risk premia in the other direction will produce some falls. However, with a little persistence and some encouragement, it will likely be walking (not running) in no time.