Figures released on Friday are expected to show that US real GDP fell in the first quarter. Although most economists believe this fall overstates the weakness of the economy and expect a bounceback in the second quarter, they are not as confident of this as they were a few weeks ago. Erik Britton at Fathom Consulting says the upturn “looks set to be weaker than we had assumed”. Because of this, many no longer believe the Fed will raise interest rates next month, but will instead postpone the rise until September.
Which raises the question: which affects equities more: the good news of looser than expected monetary policy, or the bad of a weaker economy?
History gives a clear answer: the weaker economy. Since January 1995 there has been a strong link between annual changes in the S&P 500 and in industrial production: the correlation coefficient has been a hefty 0.7, with a one percentage point-below average growth in output associated with 2.9 percentage points below-average equity returns. When output falls, so too do share prices.
This doesn’t necessarily mean that falling output causes shares to fall; it could be that both reflect a common cause, or that lower share prices reduce output. What it does suggest, though, is that there’s not much that monetary policy can do to raise share prices if the economy falters. Periods of falling output usually see interest rates fall, and yet equities do badly then.
In fact, if we control for changes in output, there is a small but significant positive correlation between equity returns and changes in the fed funds rate: the market does well when rates are rising. This is probably because a tighter monetary policy sends a favourable signal: the Fed only raises rates if it is confident about the prospects for the US economy, and investors interpret this as being good for equities.
This might seem surprising: haven’t pundits talked for years of a Greenspan/Bernanke/Yellen put? It shouldn’t. The Fed might be able to prevent a complete market meltdown by loosening monetary policy, but it cannot prevent ordinary gyrations in equities. If there is a Yellen put, it is a deep out-of-the-money one.
Investors shouldn’t, therefore, take much comfort from the fact that if the economy does falter, the Fed will further delay raising rates: history warns us that the bad news of weaker growth outweighs the good news of lower rates. For example, the Fed cut rates by three percentage points between August 2007 and August 2008 - before Lehmans collapsed - but shares fell nevertheless.
This fact is a mixed blessing for investors. The bad news is that if the economy does continue to disappoint then equities might well do badly, whatever the Fed does. The good news, though, is that if economists are right and growth does bounce back, then shares could do surprisingly well even if the Fed raises interest rates in response. Investors should worry more about the economy than monetary policy.
