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Exit Strategy is Underway. Good or Bad for the Global Equities?
November 26, 2009

The objective of exit strategy is to orderly absorb the massive liquidity brought by unconventional measures including quantitative easing. The main determinant of equity markets is earnings, not liquidity and hence the impact to the equity market is limited.


Author : iFAST Research Team



Untitled Document
Chart 1:
Chart 2
Chart 3
Chart 4: The Impact of a rate hike is limited to the equity market
Chart 5
Chart 6

Keynotes

  • Raising the rate prematurely may result in a “W-shaped” recession”.
  • Exit strategy is not equivalent to a rate hike as unconventional measures including quantitative easing has to be unwound first.
  • On the economic front, raising the interest rate by central banks is indeed a healthy signal to market because it indicates the economy is back in expansion.
  • The last two interest rate cycles in US showed that the equity market moved higher when the rate-hike cycle kicked-off.
  • The main determinant of equity markets is earnings, not liquidity.
  • Investors should eye on 2010 earnings. The valuations of the global equity markets remain attractive while the largest chunk of earnings growth would happen in 2010.

Over the past months, with the improving economic indicators, a couple of central banks have decided to raise the benchmark interest rates (Table 1). Meanwhile, investors are worried whether these series of liquidity tightening actions would depress the global equity markets as some of them presume that the market rally since March this year has been mainly liquidity-driven.

Table 1: Major countries exercising tightening monetary policies
Date Central Bank Action Comments
24 August 2009 Bank of Israel Interest rate hiked by 0.25% to 0.75% The first central bank to raise interest rates.
7 October 2009 Reserve Bank of Australia Cash Target Rate hiked by 0.25% to 3.25% The first G-20 nations to raise the key interest rate since the financial crisis.
27 October 2009 Reserve Bank of India Statutory Liquidity Ratio increased by 1% to 25% Withdrawing the excess liquidity by requiring banks to hold more government bonds.
28 October 2009 Norges Bank (Central Bank of Norway) Key policy rate raised by 0.25% to 1.5% The first European country to raise the key interest rate
3 November 2009 Reserve Bank of Australia Cash Target Rate raised by 0.25% to 3.50% Key interest rate raised for the second straight month
Source: Various Central Banks and iFAST Compilations

Conditions for an interest rate hike

With reference to the historical data, we found that for a market to enter into a rate-hike cycle, four prerequisites have to be satisfied. 1. The unemployment rate continues to decline; 2. The inflation rate remarkably picks-up; 3. An increase in domestic demand; 4. A growth in the corporate earnings

According to these prerequisites, we found that only a few countries like Australia with strong fundamentals and balance sheets are qualified for a rate hike. For the majority of the countries, raising key interest rates is still too early at present. In November, Reserve Bank of Australia raised its key interest rate for the second consecutive months to curb inflation while Bank of England expanded quantitative easing by £25bn sterling pounds to boost the economy.

Raising the rate prematurely may result into a “W-shaped” recession”

Central bankers has already learnt a huge lesson from Japan in 1990s during which the Bank of Japan tightened the monetary policy while deflation concerns persisted. US, on the other hand, should not find the 1930s Great Depression unfamiliar. In an article titled “The Lessons of 1937”, Christina Romer, the chairwoman of Barack Obama’s Council of Economic Advisers and a scholar of the Depression, addresses the risk of a “W-shaped” recession” if the tightening policies are rolled out when the recovery remains fragile. The US economy re-entered the recession in 1937 and 1938 and the unemployment rate perked up to 19% when the Federal Reserve doubled reserve requirements. Consequently, banks reduced lending and the economy contracted.

Given the variation of the magnitude and the pace of the recovery, the withdrawal of the excess liquidity is expected to be in a gradual and sequential manner. As a result, we have sufficient ground to expect that the tightening policies are unlikely to come all together at one time as policymakers do not want to-- and cannot afford to-- repeat the mistake.

Exit strategy is not equivalent to a rate hike

As the global economy recovers, these unprecedented and unconventional measures including quantitative easing and assets purchase programme has to be unwound in order to normalise the financial market. Nonetheless, some investors misinterpret the exit strategy executed by various central banks in developed market specifically as an immediate rate-hike policy. But in fact, it is not what it intends to be.

On 21 July 2009, Ben Bernanke, the Chairman of the Federal Reserve wrote an article in the Wall Street Journal, discussing the five measures that the Fed would use as an exit strategy. They are: 1. To raise the interests paid on banks’ reserves balances at the Fed 2. To arrange large-scale reverse repurchase agreements 3. Treasury sells bills and deposits the proceeds with the Federal Reserve 4. To offer term deposits to banks so as to lock-up the banks’ reserves held at the Fed 5. To sell a portion of its long-term securities holdings to the open market, if necessary The objective of these measures is very clear - to orderly absorb the massive liquidity brought and control excess reserve the quantitative easing programme so as to keep inflation expectations under control. During the course of the financial crisis, the Fed injected tremendous liquidity with an intended consequence to normalise the credit market. However, due to various uncertainties and the uptrend of risk aversion, the banks tended to put the money back to the Fed account, making the excess reserves held at the Fed spiked sharply to US$ 800 billion. The market fears that when the economy recovers, the money multiplier effect caused by these excess reserves would have a disastrous consequence. Therefore, it is an utmost concern to devise a strategy to take back these unprecedented and unconventional measures. On the contrary, a rate hike is a policy move that often occurs in the later stage when the financial market is back to normal.

When will a rate-hike cycle be back in the US?

A Glimpse of the FOMC statements

The market saw no surprise in the latest FOMC statement, but the Fed’s interpretation of the health of the economy has changed gradually since June 2009 (Table 2). Similar to the previous five statements, the Fed reiterated the two phrases: the “exceptionally low levels” of the federal funds rate will remain for “an extended period”. Notably, the statement mentions that the decision of holding the rate unchanged was with reference to the utilisation rate, inflation trends and inflation expectations. Therefore, we should pay special attention to these indicators which may signal a policy reversal. (Chart 1 & Chart 2).

Table 2: A closer look at recent FOMC statements:
Gradual change of the Fed'sinterpretation of the health of economy
4 November 2009 23 September 2009 12 August 2009 24 June 2009
Economic Activities “…has continued to pick up” “…has picked up following its severe downturn” “…is leveling out” “…the pace of economic contraction is slowing”
Financial Markets “…were roughly unchanged” “…have improved further” “…have improved further in recent weeks” “…generally improved”
Business Activities “…continued to make progress” “…continue to make progress” “…are making progress” “…appeared to be making progress”
Source: FOMC statements and iFAST Compilations

Unemployment

The latest figure on unemployment rate rose to 10.2%, the highest level since 1983, indicating that US is not yet ready to have the Fed Fund Rate raised. Our study reveals that the rate-hike cycle often comes after the peak of the unemployment rate (Chart 3). This means that we are unlikely to see a rate hike until unemployment eases.

The impact of a rate hike is limited to the equity market

Here comes the most critical question that investors would like to ask. How would the equity markets react when the rate-hike cycle returns? Some commentaries assert that raising the interest rate is negative to the equity market. The argument is as below. An increase in the interest rate is a tool of monetary tightening because it increases the borrowing costs and interest burdens of corporations. These will then discourage the incentive to borrow, which effectively constrain the loan growths and money supply. As the liquidity available in the market is limited, equity markets, in consequence, would be under pressure. Nonetheless, chart 4 tells a different story. In the last two interest rate cycles in the US, the equity market moved in sync with the Fed Fund rate. Sound contradictory? The answer lies on the relationship between the economic cycle and the interest rate cycle. Another flaw of the argument above is that corporate earnings which is the main determinant of the equity price is unmentioned. A tightening monetary policy aims at fostering the long-term economic growth and preventing the economy from overheating. It often occurs in the late recovery and expansionary stage of an economy in which normalisation of corporate earnings and new drivers foster the sustainable growth. Equity markets hence drive higher because the stronger earnings offset the negative effects brought by the tightening policy. On the economic front, central banks’ decision of increasing the interest rate is indeed a healthy signal to market. As shown in chart 4, we are currently in a situation similar to what happened in 2003 and early 2004: after the burst of IT bubbles and the 911 terrorist attacks, the Fed lowered the rate aggressively and the Bush administration approved a massive tax cut programme in order to boost economy and create jobs. The equity market reacted favourably and recorded a huge rebound when the stimulus packages came to effect in 2003. The equity market took a breather when worries over a shift of the monetary policy were aroused in 2003. However, the rally resumed when the Fed kicked-off the rate-hike cycle in mid-2004, easing the uncertainties over the policy outlook.

Move ahead of the curve: Eyes on 2010 Earnings

2009 is soon coming to its end. Earnings growth and valuation for 2009 will become less relevant in the next few months. To capture the long-term capital appreciation, investors have to shift their focus to the earnings growth and valuation in 2010 and 2011. As displayed in chart 5, the forward valuations remain at an attractive level for the purpose of long-term investing. Notably, the next largest chunk of earnings growth (Chart 6) will appear in 2010. Given that stock markets generally move ahead of the forward earnings by 6-12 months, the recent pullback marked a good opportunity and get us prepared for the long-term capital growth. To conclude, we believe that a rate hike has limited impact to global equities provided that the increase is gradual and steady. In the long run, equity prices are fundamentally determined by corporate earnings and the macro-economy. Hence, long-term investors should not be overwhelmed with worries of short-term volatility resulted from a change of the monetary policy.


iFAST and/or its content and research team’s licensed representatives may own or have positions in the mutual funds of any of the Asset Management Company mentioned or referred to in the article, and may from time to time add or dispose of, or be materially interested in any such. This article is not to be construed as an offer or solicitation for the subscription, purchase or sale of any mutual fund. No investment decision should be taken without first viewing a mutual fund's offer document/scheme additional information/scheme information document. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Investors should seek for professional investment, tax, and legal advice before making an investment or any other decision. Past performance and any forecast is not necessarily indicative of the future or likely performance of the mutual fund. The value of mutual funds and the income from them may fall as well as rise. Opinions expressed herein are subject to change without notice. Please read our disclaimer in the website.

 


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