The second week of October is coming to an end and if there is a point of particular interest is that from the third quarter of October it is common for the markets to start an upward movement which becomes more intense as we approach the end of the year. So this week, the markets found their footing and moved higher. We need to repeat that the losses recorded by both the S&P 500 and the Nasdaq are misleading as the vast majority of the stocks included in both indices record significant losses.
One of the key market issues in recent times, the most serious of which was the threat of US bankruptcy, was moved for discussion to December. Among the current open issues is pandemic handling, with US companies requiring staff to be vaccinated, third-quarter results releasing and Fed decisions following the announcement of fewer job positions.
Fed and the gradual support tapering
With the economy able to cope with the effects of the pandemic and inflation remaining high due to rising energy prices, other commodities and other factors, the Fed is forced to gradually reduce its support towards the american economy.
For that scenario, it has prepared the markets several months ago by leaking more details in an attempt to avoid a situation similar to taper tantrum back in 2013. Then, the Fed surprised the markets by announcing an urgent tapering, which provoked a violent correction and a sharp increase of the high yield spreads. Today, everyone is prepared for such a thing, given the current circumstances and especially the rise of inflation and its remaining at these levels.
According to the US Federal Reserve itself, the process is expected to begin in November and within the next 6 to 9 months, the Fed intends to eliminate bond purchases. In our view, as long as this process lasts, we do not expect that the Fed will raise interest rates as this is a decision which will be taken after the completion of the program and after taking into account three parameters:
1. Is there full employment in the American economy?
2. Is the US economy growing rapidly?
3. How much above the 2.0% target is structural inflation? (does not include fuel, food)
Knowing that the Fed has already prepared for high inflation for a longer period of time, we estimate that the Fed will be patient to see if the disturbances that led to the sharp rise in inflation will be normalized and inflation will return to the 2.0% target.
What do we expect in stocks and bonds from the tapering
First of all, we do not expect a taper tantrum event as mentioned above, and this is because this time the Fed has been completely clear and detailed in its plans for several months. In addition, there is another key reason in our view.
If we assume that a new cycle of interest rate rises begins, then given the circumstances and the current levels of government and business debt, the range of the interest rates should be between 1.75% -2.25%, because anything above will cause a domino of collapse that will have no precedent. We estimate that the rise in interest rates will trigger significant inflows (a significant part of the $ 4.5 trillion) from the money market funds to US bonds which will be more attractive and this could act as a counterweight to the Fed withdrawal.
Rising bond interest rates are not necessarily a bad development, especially as long as interest rates remain zero, as this will give a chance to large portfolios to be restructured more properly.
A pension fund or insurance company, for example, will be able to restructure its portfolio with higher-yield bonds that will facilitate the pursuit of specific returns. This rotation combined with the corrective movements of the stocks and the increase of the dividend returns makes for a better portfolio mix with a higher return.
As can be seen in the chart below, the fear of a subtle rise in bond interest rates does not “scare” stock markets, especially as long as GDP growth remains strong.