As usual, there are a litany of competing voices in the financial markets trying to make sense of what is going on and why what happened yesterday happened. There’s a lot of handwringing and worrying that goes along with the commentary. I’ve even started hearing market crash calls again from certain pockets.
One of the potentially biggest things out there (that we know about) to be focused on is probably the Federal Reserve and what it plans to do with its asset purchasing program. Shortly after the onset of the pandemic, the Federal Reserve began an aggressive program of monthly asset purchases to help stabilize the broader economy from going into freefall due to the lack of demand. There are many consequences of the Fed’s actions including higher stock prices and lower interest rates.
Increasingly, it appears momentum is building within the Federal Reserve to reduce and gradually eliminate its monthly purchases. The argument for why this is so important is because it’s unclear how much stock prices will fall, if at all, and how high interest rates may move with the loss of the Fed’s monthly purchases. Many market participants are convinced the elimination of the Fed’s purchasing program will lead to big moves down in stock prices and a big move up in interest rates. Nothing is certain, but increased volatility in asset prices is likely until we get some sort of firm direction from Fed officials. Until then there will be a lot of debate and consternation.
The chart below shows the total assets held by all Federal Reserve Banks, which includes all the assets the Fed has been purchasing, compared to the S&P 500 index level. You can see the jump in total assets in 2008 during the Great Financial Crisis. Since bottoming in 2009, the stock market has been in a very strong uptrend notwithstanding the pandemic last year.
While the Fed’s asset purchases beginning in 2008 and 2009 likely contributed to the recovery in asset markets, the broader uptrend in the US stock market continued despite the Fed’s cessation of asset purchases in 2014 and the gradual reduction in the number of assets it held on its balance sheet (i.e., it sold assets it had purchased).
While the stock market didn’t move up in a straight line up from there (by the way it rarely does), it still went higher despite the stopping of asset purchases and the selling of assets it had purchased. The moral of the story is the stock market isn’t likely going to crash when the Fed stops its monthly asset purchasing program. Furthermore, the stock market could continue to move higher despite the reduction in liquidity (money in circulation to buy assets). Side note: the winding down of the Fed’s asset purchase program is likely already reflected in asset prices, at least partly.
Is it different this time?
What’s different this time is the pandemic economy and inflationary pressures that don’t appear to be abating, at least in the near-term. Whether the shortages, disruptions and higher prices we’re currently experiencing are temporary (less than a year) or longer lasting (longer than a year) is unknown. My personal opinion is we are experiencing things right now that we never have and don’t have a lot of historical reference to guide us. That alone increases overall risk from my perspective. Whether a policy error, an unexpected weakening economy, higher than expected inflation or all the above, I feel there is a greater probability for an unexpected shock. I want to be clear, I am not making a prediction that something bad is going to happen. I’m simply stating that I think the uncertainty of future outcomes could be greater right now than it has been at similar junctures before. So while history would suggest the ending of the Fed’s purchase program is basically a non-event, maybe it’s not that straightforward this time? Regardless, disciplined investors with well-constructed plans that stick to them will navigate any future uncertainty just fine.
