A new report from Scotia Economics examines the idea that the current market conditions are similar to 1994, when the U.S. Federal Reserve embarked on notably tighter monetary policy — and it looks at the possible implications for the economy and assets.
While the market conditions aren’t exactly the same, there are a number of parallels, and the report reflects on what happened back then in various markets. Moreover, it notes that major central banks, such as the Fed and the Bank of England, are now engaged in an “unprecedented experiment in providing forward rate guidance” as they try to exit smoothly from a complex array of unconventional monetary policy instruments; adding that it’s “skeptical of the ultimate success of such policies.”
As a result, it says that investors and policymakers should contemplate the potential effects across economies and asset classes “should such guidance go awry and lead to earlier policy tightening or a serious market confrontation.”
Back in 1994, the Fed under Alan Greenspan began raising rates in February, and doubled rates to 6% within a year. “The result crushed snoozing bond markets across the curve,” the report notes. “The S&P500 stock market not surprisingly caught on to rising rates later than bond markets and peaked in early February 1994 when the first hikes began before then losing 9% of its value by early April.” This also sucked capital out of emerging markets, it says, which contributed to the Asian financial crisis of 1997-1998.
The report suggests that there are many parallels to today’s risks. Among many other implications examined in the report, it says that a protracted period of slower U.S. growth, or a renewed U.S. downturn, “would have negative consequences for Canada”, which is still heavily exposed to the U.S. economy.
“The combination of slower U.S. growth alongside higher longer-term borrowing costs would pose a risk for Canada’s interest-sensitive sectors such as housing and consumer durables spending,” it says. Adding that other vulnerable sectors include export-dependent sectors such as transportation, certain manufacturing sectors, including transportation equipment, machinery and computers & electronics; along with key resource industries, energy and forest products, which are most closely linked to the U.S.
Additionally, it notes that equity markets “could soon be challenged by the shift in U.S. monetary policy”; noting that “the Fed’s intentions to reduce the pace of asset purchases will tighten liquidity conditions with meaningful impact on regional and sector equity leadership.”
The report says that back in 1994, higher rates initially surprised investors and the S&P 500 dropped, before “investors realized the new trend in Fed policy was meant to adapt to improving macro conditions”, and markets recovered, and then went on a multi-year rally. As a result, it recalls that, from 1995 to 1997, the S&P 500 outperformed emerging markets, cyclicals outpaced yield sensitive sectors, and large caps and growth strategies outperformed too.
“Among the similarities with 1994, the shift in the Fed’s policy bias alone (from easing to tightening) could challenge risk appetite when tapering is confirmed. Once the Fed undertakes the initial reduction in monthly asset purchases, P/E contraction will likely offset earnings growth as it did in 1994. Large caps should upstage small caps while the S&P 500 could sustain outperformance versus [emerging markets],” it says. And, it says, cyclicals should beat yield sensitive sectors.
“Among the differences with the 1994 cycle, we believe an extended period of lacklustre bond returns could set the stage for multi-year asset rotation that would benefit equity flows,” it adds. “Similar to 1994, equity leadership over bonds is expected to continue. However, absolute equity gains are unlikely to reach the magnitude witnessed in the post-94 cycle,” the report says, adding that the S&P 500 rally in 1995-1996 “was driven by both earnings growth and significant P/E expansion with the latter supported by early 1995 Fed rate cuts. Such a powerful combination appears unlikely in coming years.”