What Fed pauses could mean for investors

Central banks may be approaching a neutral interest rate and reaching the end of their tightening cycle after years of fairly predictable increases, leading observers to wonder whether there will be a renaissance of 1990s-like volatility. The place to look is emerging markets, says a recent note by TC Bank Financial Group economist Richard Kelly, called “Da Vinci’s Other Code: Increased Global Financial Volatility to Come.”

By Kelly’s account, investment returns have become less volatile. From 2002 through mid-May 2006, global financial markets enjoyed an unprecedented, uninterrupted, universal streak of stellar returns with little volatility.

This, however, could well be the product of temporary regime shifts. For one thing, most international equity markets are now much more closely correlated to the main U.S. equity benchmark, the Standard and Poors’ 500. Comparing the 1995-2001 and the 2002 -May 2006 periods, global stocks are now 20% more correlated to U.S. market moves than they were previously, while emerging markets are seeing a 34% greater correlation.

Just about every market has done better in the second period than the first, with the exception of the U.S. and China. As well, the Chinese market has seen its correlation to the U.S. market skyrocket 144% during the second period..

Strategists across the street at CIBC World Markets say markets need to get over a number of worries and fears, including the fear of further rate hikes, in order to set new highs going forward. But they too are taking their lead from the 1990s.

Economist Avery Shenfeld says there are clears signs that central bankers are “the equity market’s friends in high places,” particularly in Canada where inflation is better contained, and are ready to back off to reignite growth if necessary.

CIBC’s report says tepid performance in the second quarter has encouraged the Fed to join the Bank of Canada on the sidelines, but the 1995 experience may provide the best guidance for the future, given the number of similarities with the present. Analysts say they favour energy and other resource cyclicals like the base metals and gold segments, explaining that “still impressive TSX earnings momentum also warrants a continuing overweight on stocks,” and that the end of monetary tightening “has prompted us to add the utilities group as a new pick..” The potential end of rate hikes is also leading analysts to suggest that a continued double weight in income trusts is warranted. The group has downgraded the industrial sector to a neutral choice, meanwhile, given its potential exposure to moderating U.S. growth.

“With both the Fed and Bank now on hold, that should help insulate Canadian equity markets against a measured, ongoing U.S. growth slowdown,” says Shenfeld. “Stocks rallied after the Bank and the Fed both retreated to the sidelines in broadly similar circumstances in 1995. Historically, rate pauses not prompted by recession are a plus for equities.”

But the more important part of the story is that volatility is down 4% across global markets, with markets such as Toronto and Sydney experiencing a 20% decline in volatility, reflected in their continuing, commodity-fuelled expansion. Emerging markets have seen an almost 30% decline in volatility since the 1990s, a situation that Kelly says could change with the end of the Fed’s rate-tightening cycle.

To be sure, there are a host of explanations for declining emerging-market volatility: for example, balance sheets are in better shape than they were during the baht and rouble crises; and, to some extent, although their impact is arguably exaggerated, hedge funds seeking to tap higher risk premiums have added liquidity by using the carry trade — borrowing cheap money in 0%- interest Japan — to fund emerging-market investments.

The premium on emerging-market debt, meanwhile, is down to near-historical lows: 200 basis points over U.S. Treasuries, compared to 1998 when the spread gapped out from 500 basis points to 1500 —15% over equivalent U.S. debt instruments — putting the risk back into emerging markets.

But Kelly prefers to consider a more traditional factor as a possible explanation: the interest rate cycle. He says through the 1990s, the highest market volatility came as interest rates were rising, but there was also high volatility during the “no-man’s land” interim period when it wasn’t certain whether the Fed would continue to tighten rates, or start to loosen them. That was especially true of emerging markets, but also, naturally, of U.S. markets.

“The crucial source of volatility is the end of one of the most stimulative global monetary cycles in history,” he says. “With future tightening, uncertain markets have become skittish, responding sharply to new information.”

So what do we know that we didn’t know before?

“Before judging new-age arguments for why it’s different this time,” Kelly says, “a look at the largest economy in world reveals an all-too-common-twist — the U.S. did it. Over the last 22 years, volatility in the U.S. market has been nearly 10% higher during the `Fed-watching’ stage as interest rates near their peak.”

Kelly’s ending wisdom on interest regimes is: “When monetary policy is on auto-pilot, equity returns have been historically low. It is only with the risk of chance that higher returns have been seen.”

Higher risk equals higher return, anyone? Or as Kelly concludes: “Central bankers may be responsible for more drama than we’ve been led to believe.”

Filed by Scot Blythe Advisor.ca, scot.blythe@advisor.rogers.com

(08/10/06)

Scot Blythe