A triple push of policy tightening, comprising quantitative tightening, fiscal correction and rate hikes, against the backdrop of Russia’s invasion of Ukraine, inflation and social disparities, will test the “reflation trade” set up two years ago by many asset managers. Yet, by exacerbating stagflation and stock market jitters, central banks and governments will refrain from achieving anything close to historical norms of monetary and fiscal policy.
The global recovery has been vital for risk assets and the recovery. The damage to equities in early 2020, ahead of fiscal plans, was both pure and relative to “safer” government bonds (Chart 1). This relative success eclipsed that of 2008-2009, reflecting the tightening in bond prices established over a decade of quantitative easing.
But the relative rally in equities since the second quarter of 2020 and the drop in expected volatility have been impressive, bringing the equity-bond yield differential back to its pre-Covid-19 level. Based on forward earnings, it was even close to 2007 levels. Much of this must be due to monetary expansion and fiscal spree since 2020.
Figure 1: High equity markets had retreated
US stock and bond yield spread (using the S&P 500 Composite and 10-year Treasury) versus the VIX volatility index. Gray is the US recession
Source: Refinitiv data feed
Comparing the balance sheet of the Federal Reserve and the S&P 500 since the start of QE in 2008 gives a simple correlation, as high as 0.88. The relationship is strongest with a lead of 10 weeks, suggesting that the S&P has, on average, anticipated QE changes by two to three months. The symmetry for QT suggests a similar preemption, although in the opposite direction. On that basis, shrinking the balance sheet by gradually reinvesting fewer maturing bonds — something the Fed hinted at from March with the European Central Bank a bit later — would erode important support for stock markets.
More powerful could be the fiscal correction, already signaled in the US and UK. A notable difference in 2021 is the strongly positive contribution of stimulus to growth assets; it was negative in 2008. This reflects the overall approach to 2020, with fiscal programs reinforcing monetary stimulus.
For policymakers, the test will be how much the withdrawal of stimulus hurts the real economy. The US unemployment rate, a long-term gauge of global activity, has shown a simple correlation with the S&P 500 of just -0.23 since 1964, showing a nine-month lead. Restricting this to the period since 2008, when QE came into effect, yields a stronger correlation of -0.83, with the same lead.
The price/equity ratio estimated by S&P exhibits much greater long-term fluctuations than the stock market index itself. The comparison with the unemployment rate similarly offers increasing correlations of -0.55 and -0.71, for 1964-2022 and 2008-22 respectively, with an lead of eight months.
This is even with the short-term relationship severing in 2020, as job losses in the United States reached breathtaking levels. However, the ability of the S&P’s price-to-equity ratio to reach new highs in 2020, before Covid-19 vaccines became available, suggested that a record stimulus was enough to reassure markets that the recession and job losses would be temporary.
Chart 2: Risky assets priced in further macroeconomic improvements
Estimated p/e ratio for the S&P 500 Composite Index (right) versus the US unemployment rate (reverse axis).
Source: Refinitiv Datastream, based on US Bureau of Labor Statistics data
This underscores that the importance of employment as an indicator of demand for risky assets has increased over time as labor markets have become less regulated. Additionally, changes in these assets typically preempt QE – and presumably QT – changes by up to three months. In employment it is up to nine months. Hopes of sustaining the recovery and sustaining stimulus trade would rest, even without the Russian invasion of Ukraine, on further job gains. Failing this, more stimulus, notably budgetary, would be necessary.
However, the reverse is more likely. Policymakers are talking about a “correction” and hopes for reflationary wage growth could be trampled if liquidity and stimulus dries up. This suggests that QT, less accommodative fiscal stances and the realization that the best of the jobs recovery may be past could, without offsetting measures, test growth assets – even if the Russian-Ukrainian war is over. quickly resolved.
Neil Williams is Chief Economist at OMFIF.