Mario Draghi’s hint last month that the European Central Bank’s bond buying may not continue forever unleashed a storm of panic among the perma-bears who still dominate the media and market commentariat. But its actual effect on markets themselves has so far been close to minimal. So should investors worry—or relax—about a repeat of the “taper tantrum” in May 2013, when Ben Bernanke first hinted that the Federal Reserve would eventually start to wind down its quantitative easing?
At the time, I compared the US taper tantrum to a fire alarm in an office building, and asked whether it was a signal of genuine danger, a false alarm or a useful fire-drill. I concluded that gradually removing quantitative easing would turn out to be a false alarm for US and developed world equities, a fire-drill for bond markets, and a genuine danger for emerging market equities and bonds (see Fed’s Fire Drill Obscures The Real Risk). Today, I believe there are two arguments for genuine concern about the impact of ECB tapering, offset by three reasons why taper-related setbacks should be treated as buying opportunities, especially for small and mid-cap European equities and other domestic-demand related assets in the eurozone.
Let’s start with the good news. Firstly, ECB tapering will not even begin until sometime in 2018. And given Draghi’s determination not to repeat the mistakes of his predecessor by tightening policy prematurely, the ECB’s balance sheet will almost certainly continue expanding until well into 2019, and interest rates will remain near zero for even longer (see Draghi’s Two Ps And The Euro). Thus tapering will not amount to a monetary tightening or a withdrawal of stimulus, but merely a reduction in the amount of additional stimulus to the eurozone economy.
Moreover, once the ECB does feel ready to “tighten” policy, it will likely deviate from the Fed’s road map by raising interest rates from -40bp to zero before terminating its QE program. This sequencing will help to guard against any widening of spreads in the peripheral bond markets and will mean that the first phase of tightening will be greeted as a bullish and popular event, especially by bank shareholders and German savers.
For this reason, a gradual reduction in bond purchases and an exit from negative interest rates should help to reinforce the renewed Franco- German political cooperation following Emmanuel Macron’s election (see The Real Macron). This gives investors a second reason to treat Draghi’s hints about tapering as a bullish, rather than bearish, event for European assets, since tapering, when it happens, will reinforce goodwill on the German side, especially if the ECB exits negative rates.
Thirdly, and perhaps most surprisingly, the experience of Fed tapering shows that normalizing monetary policy can be very positive for equities, provided it is carried out in a gradual and careful way. Contrary to the almost unanimous consensus among media commentators and market economists, equity prices do not depend mainly on liquidity conditions or on the expansion of the central bank’s balance sheet. The evidence that tapering can be good for equities is clearly visible in the left-hand chart overleaf, which shows the breakout of US stock prices from their 13-year trading range in early 2013; a breakout I have often cited as confirmation of a structural bull market (see Goldilocks And The Ten Bears).
What I did not realize when the breakout happened in spring 2013, was that Bernanke would deliver his notorious speech provoking the taper tantrum just a few weeks later, on May 21. That speech caused a one month -5% sell-off on Wall Street. But by the end of 2013 the S&P 500 was 20% above the taper tantrum low. US equities continued to rise almost without interruption until the middle of 2015.
It is clear, therefore, that Fed tapering in 2013, far from signaling the end of the post-crisis equity rally, helped to power Wall Street’s breakout from a long term bearish trading range and into a sustained bull market that is still going strong today. How can we account for this apparent paradox?
One possible explanation is that Fed tapering finally refuted the widespread belief that the post-crisis economic recovery was entirely dependent on ever larger injections of monetary stimulus. Conventional wisdom at the time maintained that once the withdrawal of the performance-enhancing drugs began, the US economy would go cold turkey and that asset prices—artificially and unsustainably pumped up by monetary steroids—would quickly deflate.
Instead of collapsing, financial sentiment and equity prices were reinforced once it became clear that the economy could handle the withdrawal of monetary stimulus, and that the US was shifting out of a cyclical recovery fuelled by extraordinary monetary stimulus and into a sustainable long term expansion driven by the normal market economy process of steadily rising employment and growth in private demand.
All of which brings me to the bad news. Firstly, Fed tapering occurred at a time when Europe and Japan were gearing up to expand monetary stimulus. But when the ECB tapers there won’t be another major central bank preparing a massive balance sheet expansion. It could still turn out, therefore, that the post-crisis recovery in economic activity and the appreciation of asset values was dependent on ever larger doses of global monetary stimulus. If so, the prophets of doom were only wrong in that they overstated the importance of the Fed’s balance sheet, compared with the balance sheets of the ECB and Bank of Japan.
This is a genuine risk, and an analytical prediction about the future on which reasonable people can differ, unlike the factual observations above regarding the revealed behavior of the ECB, the Franco-German rapprochement and the historical experience of Fed tapering.
Secondly, it is likely that the euro will rise further against the US dollar if the ECB begins to taper and exits negative interest rates. A stronger euro will at some point become an obstacle to further gains in European equity indexes, which are dominated by export stocks. However, a stronger euro may not necessarily harm the shares of domestically-oriented companies, or even those of export stocks expressed in US dollar terms.
In fact, it is quite possible that a substantial part of the performance gap that has opened up between US and European equities since the Fed’s taper tantrum will be closed by currency movements, rather than by the relative performance of equities as expressed in domestic currencies. This is what happened from 2003 to 2007, when European equities outperformed US equities by 30% in local currency terms, but by 80% in US dollars (see the right-hand chart below). Something similar could easily happen over the next few years, regardless of whether or when Draghi decides to drop more hints about tapering by the ECB.
This article originally appeared at Gavekal Research.