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The world’s central banks have been unusually kind to investors over the past year-and-a-half, as low interest rates and other monetary stimulus boosted the appeal of stocks. But the tone is now changing, generating uncertainty over whether the bull market can persist.
Economists at Bank of Nova Scotia expect the Bank of Canada will hike its key rate – held at just 0.25 per cent since the start of the COVID-19 pandemic – eight times by the end of 2023. And some observers expect the U.S. Federal Reserve will start to withdraw stimulus as soon as next month, with rate hikes starting within a year.
“The Fed is moving to a new monetary regime. Full stop,” said David Rosenberg, chief economist and strategist at Rosenberg Research.
The impending changes come at a precarious time for investors.
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The Standard & Poor’s 500 Index has nearly doubled from its pandemic lows in March, 2020. Other major stock market indexes, including Canada’s S&P/TSX Composite, are near record highs and equity valuations are at levels last seen during the dot-com bubble of the 1990s.
That leaves little room for disappointment among investors who have counted on central bank policies to reward risk-taking and keep stock markets rising.
Soon after the pandemic slammed into North America in 2020, with a devastating impact on employment, the Federal Reserve, the Bank of Canada, the Bank of England, the European Central Bank and many other central banks slashed their key interest rates to avert economic collapse.
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Some also borrowed a tactic many central banks used during the global financial crisis more than a decade ago: buying bonds to push down bond yields, and thereby borrowing costs, even further under a program known as quantitative easing (QE).
Add government assistance, such as monthly payments to sidelined workers, and the total amount of fiscal and monetary stimulus created worldwide during the pandemic comes to a remarkable US$32-trillion, according to Bank of America.
That was enough, it seems, to jolt economies back to life. It also propelled stock markets to dizzying heights as the stimulus lifted corporate profits and made stocks shine brighter next to low-yielding bonds.
Benchmark interest rates
Daily, per cent
U.S. (lower bound)
Canada
2
.
4
%
2
.
2
2
.
0
1
.
8
1
.
6
1
.
4
1
.
2
1
.
0
0
.
8
0
.
6
0
.
4
0
.
2
0
.
0
2016
2018
2019
2020
2021
THE GLOBE AND MAIL, SOURCE: BANK OF CANADA;
U.S. FEDERAL RESERVE
Benchmark interest rates
Daily, per cent
U.S. (lower bound)
Canada
2
.
4
%
2
.
2
2
.
0
1
.
8
1
.
6
1
.
4
1
.
2
1
.
0
0
.
8
0
.
6
0
.
4
0
.
2
0
.
0
2016
2018
2019
2020
2021
THE GLOBE AND MAIL, SOURCE: BANK OF CANADA;
U.S. FEDERAL RESERVE
Benchmark interest rates
Daily, per cent
Canada
U.S. (lower bound)
2
.
4
%
2
.
2
2
.
0
1
.
8
1
.
6
1
.
4
1
.
2
1
.
0
0
.
8
0
.
6
0
.
4
0
.
2
0
.
0
2016
2018
2019
2020
2021
THE GLOBE AND MAIL, SOURCE: BANK OF CANADA; U.S. FEDERAL RESERVE
But central banks are signalling this era of extraordinary stimulus is nearing an end.
Among emerging market countries, Chile, Brazil, Poland, Russia and others have hiked interest rates. In developed countries, Norway and New Zealand have raised their rates, and economists expect other central banks will follow.
The Bank of Canada is already reducing its bond purchases, known as tapering. And recent reports from the Federal Reserve show officials expect U.S. tapering could start next month, with the Fed potentially ending its bond-buying program by mid-2022 – faster than many economists had expected earlier this year.
“All central banks have moved in the same direction, and there’s a one-word explanation: inflation,” said Benjamin Reitzes, an economist at Bank of Montreal.
In the United States, the consumer price index rose 5.4 per cent in September, compared with a year earlier, which is well above the Fed’s target of 2-per-cent inflation. In Canada, the comparable figure is 4.4 per cent, the highest rate in 18 years.
Some observers expect that efforts to rein in inflation through monetary tightening could unleash turbulence in financial markets, ending an unusually smooth ride for stocks over the past 19 months and possibly skewering a bull market heavily reliant upon stimulus.
“What QE does well is it gives a bid to risky assets and it holds down volatility. When you taper, and then eventually tighten, those things go into reverse,” said David Jones, director of global investment strategy at Bank of America.
In other words, tapering could push investors toward safer assets and overall market volatility could rise, in a transition that might not be slow or smooth.
“There is a risk of episodes of disorderly volatility,” Mr. Jones said.
To be sure, there’s good news here. The conditions that drove the need for extraordinary stimulus during the worst days of the pandemic are now easing. The U.S. unemployment rate has fallen to 4.8 per cent, down from a pandemic high of 14.8 per cent in April, 2020.
The U.S. economy expanded by 2 per cent in the third quarter, at an annualized pace. While that’s slower than the 6.5-per-cent growth in the second quarter, it was largely attributed to temporary conditions such as supply constraints and an upsurge in COVID-19 cases.
Corporate earnings for the S&P 500 surged 96.3 per cent in the second quarter, year-over-year, according to Refinitiv. Midway through the third-quarter reporting season, earnings are up 38.6 per cent.
“If we’ve achieved the original goal of averting deflation and depression risk, then the need for stimulus has passed. It’s a nice problem to have,” said Derek Holt, head of capital markets economics at Bank of Nova Scotia.
But these are unusual times. There is no template for removing enormous amounts of stimulus following a global pandemic.
As well, supply chain bottlenecks, droughts and labour shortages are driving up prices for everything from cars to food. That raises the question of whether central banks are even equipped to address this supply-induced type of inflation.
“The current environment is one that is exceptionally challenging for central banks to navigate,” said Frances Donald, chief economist and strategist at Manulife Investment Management.
“The Bank of Canada could hike interest rates 10 times over the next two years, and it would not open up ports in southeast Asia or make it rain in Brazil,” Ms. Donald said.
Her concern is that investors could face a particularly tough combination: If central banks are too eager to hike interest rates, the tighter policy won’t succeed in taming inflation, but it will slow economic growth.
Mr. Rosenberg expects that lower government spending will be a drag on economic growth next year, while tighter Fed policy will weigh on abnormally high stock market valuations.
“So I think you’re going to have two forces at play: reduced earnings expectations bumping against reduced price-to-earnings multiples. That’s what leads you to a flat market at best, if not a series of rolling corrections,” Mr. Rosenberg said.
Some observers expect financial markets can get through this next cycle of monetary policy without major setbacks, though. That’s because central banks have more or less telegraphed their intentions, giving investors plenty of time to get comfortable with the changes.
The yield on the 10-year U.S. Treasury bond is back above 1.5 per cent, from below 1.2 per cent in early August, implying that markets are pricing in higher interest rates and inflation (as yields rise, bond prices fall). The Government of Canada 10-year bond touched a pandemic high yield of 1.7 per cent this week, up from about 1.2 per cent in August. And while major stock indexes declined in September, they have rebounded this month – a sign that equity investors remain calm.
The bullish case for stocks also rests on the idea that interest rates, even after hikes, will remain low enough to provide ample support for the economy as inflation eases, allowing the economy to expand further even if economic growth rates subside from recent peaks.
“I’d push back on the idea of peak economic growth. It suggests that you’re slipping into an abyss or rolling into a recessionary window. That couldn’t be further from the truth,” said Tom Porcelli, chief U.S. economist at RBC Capital Markets.
He expects that the U.S. economy will expand by about 4 per cent in 2022.
History also suggests investors shouldn’t necessarily dread monetary tightening. New York-based Cornerstone Macro looked at previous rate-hiking cycles and found that stock valuations – specifically price-to-earnings ratios – typically go down when interest rates go up. Yet the S&P 500, the firm noted, has risen over the past six rate-hiking cycles going back to 1983.
During the previous cycle, when the Fed increased rates from 2015 to 2018, the S&P 500 rose 22.6 per cent, implying there is little to fear from simply staying put in the market.
Even under gloomy scenarios, some observers say investors should position themselves for change, rather than exit the stock market altogether.
Generally, recommendations follow a playbook: Avoid sectors that tend to perform well when interest rates are falling, such as technology, and instead favour economically defensive sectors such as health care, consumer staples, telecommunications and utilities.
Richard Bernstein, a former strategist at Merrill Lynch who now runs Richard Bernstein Advisors, a New York-based investment manager, argues that central bank stimulus has created asset price bubbles that are set to pop as rates rise. He points to cryptocurrencies, along with disruption and innovation plays within the technology sector.
But he likens markets to a seesaw, with asset bubbles on one side and everything else on the other, including some pretty good investment opportunities.
“There’s this notion that when a bubble pops, it’s calamitous. But I’m not quite sure that’s the way people should be thinking right now,” Mr. Bernstein said.
Instead, he likes areas of the stock market where companies haven’t been investing enough in their operations – areas that are now in high demand. That includes the energy sector and logistics infrastructure – or, more generally, industrials. He also expects financials will perform well because rising interest rates will make lending more profitable.
Broad indexes might not perform well during this period of monetary tightening, Mr. Bernstein said. “But it doesn’t mean that your stock portfolio has to do badly. You can actually do really, really well.”
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David Berman