S&P 500, QE and the evolving market narrative

by George Hatjoullis

The Federal Reserve of the USA has hinted that it may be within sight of a phased exit from Quantitative Easing. The S&P 500 reacted adversely. The question is why should it do this? The Fed did not suggest it would exit QE come what may. It made clear that exit was contingent on the Federal Reserve’s assessment of the economic outlook. Moreover, there is no evidence, either from current statements or past behaviour, that the Fed will do other than err on the side of caution. The market reaction thus needs some explaining.

To react negatively to the prospect of QE being removed is a little like relatives reacting negatively when their loved one is taken off life support. It implicitly reveals a sense of distrust of the medical staff. However, it also reflects a deep sense of uncertainty and fear of the outcome if the judgement of medical staff is incorrect. Doctors are not infallible and if the judgement is wrong then the loved one dies. The negative reaction relates to this possible outcome and not the competence of medical staff or the probability of the loved one dying. Remember that real people work under uncertainty models and not probability models as past blogs have been at pains to illustrate.

The USA has been on QE life support for so long that the market fears the removal lest the US economy regress. The simplistic market narrative is that the stock market has risen despite the economic outlook because of the cheap and plentiful supply of central bank money. There is some truth in this. QE has kept the risk free rate low for an extended period and this has allowed the falling risk premium to boost share values. However, the discount factor is not actually independent of the cash flows it is discounting.

There are two elements to asset valuation; the discount factor and the prospective future cash flows being discounted. The discount factor, as was explained in a previous blog, is conceptually composed of a risk free rate and a risk premium. The removal of QE should, other things being equal, bias the risk free rate to move up. However, the act of removing QE should also affect the risk premium. If the Fed’s judgement is trusted then it should reduce the risk premium. If QE is no longer necessary then things must be looking up. However, there is some uncertainty and the initial market reaction will  be cautious and fixated on the worse possible outcome. The other element is that the Fed’s judgement of the economy is correct, then the business environment is improving and the size of prospective cash flows must be greater.

There are thus two possible narratives as the QE removal story unfolds. The first focuses on the rising risk free rate and the possibility the Fed is premature. The uncertainty dominates and investors err on the side of caution and the market corrects. The second focuses on the positive signal from the Fed that it feels that the economy no longer needs life support and the consequent positive implications for risk premium and prospective cash flows.

Given the extended run up in equity prices it is likely we will see the first narrative dominate initially. If the patient continues to prosper as life support is removed then the second narrative will come in to play. The Fed has until now been very cautious and careful not to spook the markets. There is no reason to think this bias to err on the side of over easy policy is about to change. It is most likely that if QE is removed it will signal a genuine belief by the Fed that the US economy no longer needs life support. The outlook for the S&P 500 depends on how quickly the market accepts this to be the case. It may not take that long.