Markets: Beyond tapering

Worries about the market reaction to US Federal Reserve’s tapering plans may be overdone.

Explicitly, quantitative easing has nothing to do with the equity market. It is expected the liquidity tap will be turned down, but the fear it will send equity markets plummeting is really not a plausible aftermath.

The purpose of quantitative easing was to reduce borrowing rates for financial institutions below the official federal funds rate, which had already been slashed to 0.25 percent. On this front, quantitative easing has been successful.

There is a myth that lower interest rates impact earnings but the reality is over the long term, financial institutions and real estate infrastructure trusts are the only sectors where interest rates really influence earnings. So we can discount rising interest rates as a cause for a falling equity markets.

Equity markets have arguably been a beneficiary of quantitative easing, though it is difficult to unravel the direct cause of this. The stimulus measure encouraged both investor confidence and spending, pushing the market up along the way.

Unless a reduction in quantitative easing results in earnings being adversely impacted, it is going to be hard to justify an extended slide in equity prices. As a forward-looking indicator, share prices and the share market should reflect the present value of future earnings.

At the moment, pressing issues for both the Australian and US equity markets come from actually being able to deliver the goods of earnings in the future.  On a valuation basis, the ASX 200 is roughly trading in line with long-term averages – looking forward, it would mean earnings need to increase from current levels to justify existing valuations.

Forward guidance from the Federal Reserve, expected on Thursday morning local time, is going to be equally important as the tapering schedule itself. It will be about managing investor expectations of future interest rates and growth. It really comes down to the perception the Federal Reserve creates about the future. Let’s not forget, central banks precisely offer liquidity – they are not the actual creators of wealth. But they can (and should) set realistic expectations for markets and investors.

Any market fears the Federal Reserve will taper too early or aggressively could be exaggerated. You would imagine they would quickly turn the liquidity tap back on if the outcome was detrimental to their economic targets. There are no rules to say they can’t go back.

The problem now facing financial markets and investors alike is navigating the consequences of the withdrawal of a sustained, unconventional policy.