Societe Generale with the note:
The ongoing post-pandemic monetary easing cycle started with the first rate cut of July 2019 after tightening reached a peak in December 2018. After two cuts, the Fed policy rate had declined to 1.75% by February 2020 from a tightening peak of 2.5%. With the global pandemic bringing economies to a stand-still, monetary policy went into overdrive in the following month, with further rate cuts and a series of unconventional QE policies that provided extraordinary liquidity support. As a consequence, the shadow rate, reflecting the overall monetary policy stance, fell precipitously by a total of about 790bps, and appeared to have bottomed out by the end of May 2021. This compares well with the plunge of about 850 bps in shadow rates at the trough of the post-GFC easing cycle in November2013. Given that the economic slowdown that precipitated the easing cycle was not a cyclical downturn typical of normal business cycles, this was one of the shortest easing phases historically. It was also a testbed of massive unconventional policies.
Focusing on the most recent cycles, the figure below shows the degree of monetary easing since the mid-1980s. In the last two cycles, unconventional policy measures in the form of QE have contributed a large part of monetary easing. In the post-GFC cycle of monetary easing, after three rounds of QE, forward guidance and other unconventional policies, the cumulative short rate fell by 850 bps over an extended period of five years, bottoming out in November 2013, a month before the start of QE tapering. In the process, the QE measures accounted for about 62% of the total monetary easing during the cycle. Of the total monetary easing provided in the ongoing post-pandemic monetary easing cycle (790 bps), by our estimates, more than65% could be attributed to the series of large-scale QE measures implemented in 2020.
The duration of monetary easing phases varies considerably across cycles. The longest easing period in recent history was the post-GFC phase that started with a rate cut in September 2007 (right-hand figure above). In the face of deteriorating economic conditions and the deflationary pressures of the post-crisis period, the QE-infused unconventional policy easing continued for 75 months through to November 2013 when the shadow short rate began rising, due to upcoming tapering of QE and improving economic conditions overall. The current easing phase, by contrast, is the shortest, lasting about 30 months, reflecting the non-cyclical nature of the pandemic-induced crisis.
Similarly, the tightening phase of the post-GFC cycle was one of the longest, running from November 2013 to the rate peak of December 2018 (right-hand figure below). Although the policy rate rose by only 2.5% over the course of the Fed’s policy rate hikes, the overall impact of the policy tightening (including QE tapering, forward guidance, and balance sheet
contraction) was to effectively push rates up by more than 6% at the monetary tightening peak (left-hand figure below).
Monetary policy cycles and equity strategies
With the bottoming-out of the cumulative shadow rate, a new phase of monetary tightening might be currently underway. Although an explicit policy rate hike is not expected until 2023, moderation of the QE measures in the form of tapering is increasingly discussed. From the recent post-GFC monetary policy experience, given the glut of liquidity in the markets and ballooning Fed balance sheet, it is reasonable to expect a tightening cycle to follow a natural chronology starting perhaps with a tapering of QE and balance sheet contraction before an outright uptick in the fed funds rate.
The turn of monetary policy from an easing phase to a tightening phase indicates the strong footing of an expanding economy, along with some policy concern about overheating and potential inflation. As such, it also calls for realignment of investment strategy positioning – generally a move from cyclical strategies that would have benefited from the initial economic recovery and monetary accommodation policies to aggressive, sustainable pro-growth strategies.
The relation between monetary policy cycle phases and broad equity market performance is not clear-cut. In the context of the discounted cash flow model of equity valuation, stock prices represent the present value of future cash flows. Accordingly, monetary policy impacts equity performance through its effects on both the discount rate (the direct effect) and investors’ expectations of future economic activity (the indirect effect). Conventional wisdom holds that accommodative policy should support equity valuation through lowering the cost of capital and stimulating economic activity and firms’ aggregate earnings, while monetary tightening will lower equity prices given its implied higher discount rate and/or lower expected economic activity and aggregate earnings.
On the other hand, periods of loose monetary policy, particularly in the late cycle, have historically coincided with recession and poor economic growth that generally depress equity valuations, while restrictive monetary policy and rising interest rates are generally indicative of stronger economic prospects, particularly in periods of benign inflation, which supports strong equity performance.
Empirically, this relation over the last 60 years appears to have been regime dependent. Indeed, monetary tightening cycles were associated with lower equity performance in the 1970s and80s when restrictive policy primarily aimed to choke off runaway inflation; this is consistent with the extensive empirical academic research that supports the theoretical predictions outlined above.
However, following the success of monetary policy in containing inflation under Paul Volker’s Fed in the early 1980s, there has been a significant regime shift, with inflation being less of a threat in recent periods (and with the fight against deflationary tendencies dominating policy decisions instead), coinciding with the Great Moderation – the period of low inflation and positive economic growth. As a result, the broad equity market has appeared to be more buoyant during a monetary tightening phase than during monetary accommodation in the most recent cycles when tighter policy has not coincided with runaway inflation, contrary to the hyperinflation periods of the 1970s and 80s. The S&P 500 has registered annualised returns of about 12% per annum across tightening phases versus only about 4% during monetary easing phases over the 30 years since 1990. Similarly, in the post-GFC monetary cycle (2007-2018) alone, the broad market rallied by about 9% per annum during the tightening phase starting in November 2013 while gaining only about 3.3% per annum during the easing phase. Regardless of the inflation path going forward, monetary tightening might be dictated by the need for normalisation of rates from their historic lows, which would have potential to support equity market rallies similar to the post-GFC experience.
At the equity style level, cyclical strategies, particularly Value and Size, tend to fare better during monetary easing, partly because the easing phase overlaps with the period of early economic recovery in the business cycle that is highly conducive to a cyclical rebound. Defensives such as Quality and LowVol struggle during the tightening phase, with the economy charging ahead and markets rallying. On the other hand, relative to their challenges during monetary easing, growth-oriented strategies, including Profitability(which focuses on high-quality profitable firms), and secular Growth strategies, tend to do well during the tightening phase. However, the fortunes and challenges of Growth are generally concentrated in the late economic cycle around peak tightening; its relative performance varies outperforming as we approach the peak of tightening and underperforming after the monetary policy brake during the ensuing slowdown in economic activities.