S&P 500 and tapering revisited: FOMC 18 September

by George Hatjoullis

The date for everyone’s diary should now be 18 September. This is the date of the next FOMC meeting announcement by the Federal Reserve of the USA. It will come with a summary of economic projections and a press conference with Chairman Bernanke. It is widely expected that it will also mark the beginning of the end of Quantitative Easing.

There is still widespread unease about exit from QE by the Fed. This is despite the fact that Japan and even the eurozone seem inclined towards easier monetary conditions for some time to come. Moreover, the Fed are not planning a hand brake turn in monetary policy, which is why the policy shift is being referred to as tapering. Nevertheless, nervousness in financial markets about even this gentle policy shift is evident.

Underlying the nervousness is an implicit lack of faith in the Fed and in the sustainability of the economic recovery. The world economy is chugging along quite nicely, all things considered, but below what many believe to be ‘potential’. The notion of potential output is beloved of economists but not one I have much faith in. It is a theoretical concept which is, ex ante, unobservable. It reeks of a rationale for interventionism. The economy is not achieving potential so the government or the Central Bank should do something. Really?

Educated as an economist, and a Keynesian to boot, 30 years ago I would have concurred with this economic view-point. However, after thirty years on the front line of markets and price formation, my faith in intervention has dimmed somewhat. Markets are the tail that wag the dog. If the economy is growing at 2% then for all practical purposes that is the potential. The reason we have economic fragility at the moment is not because of the lack of intervention but because of too much of the wrong kind trying to undo the consequences of past intervention errors. The eurozone is a good example with its ‘austerity’ programmes.

This is not to say that intervention is never appropriate. The Fed action in the wake of the 2008 crisis was vital. The concern was to stop structurally negative inflation expectations arising and this has been achieved. Abe in Japan is now trying to undo failure to stop such a situation developing in Japan. However, such targeted monetary intervention cannot continue indefinitely and it risks creating new problems. For the Fed it is job done and, frankly, well done. The economic risk from tapering is non-existent.

However, this will not stop markets worrying about tapering and responding to perceived risks. As noted in previous blogs, it is all about narrative construction and a negative narrative on tapering prevails. It will prevail until tapering begins and the sky does not fall in. What does this all mean for the S&P 500?

The S&P 500 has recovered from the first tapering scare and made a new high. In part this reflects the pattern of data which has been comfortable but not so strong as to make the initiation of tapering near term a certainty. One could even be lulled into the idea that tapering is no longer a negative market narrative. Do not be so lulled. As 18 September draws closer nervousness will intensify, if not sooner. Once September comes around, the negative tapering narrative will loom large and could bring with it another corrective move lower in the S&P 500.