October 24, 2016    4 minute read

Should Equity Investors Worry About ECB Tapering?

Market Cooldown    October 24, 2016    4 minute read

Should Equity Investors Worry About ECB Tapering?

On October the 20th, the ECB decided to keep interest rates steady. However, in March 2017 the quantitative easing program will formally come to an end. Will the ECB extend its €80bn monthly asset purchase program?

The ECB And The Markets

This question has been puzzling the markets, raising uncertainty about a possible tapering – i.e. a gradual reduction of the assets purchased by the ECB via its program. Indeed, while Mr Draghi said that the governing council did not discuss extensions of the program, he made it clear (as usual) that the ECB will pursue the program until the Eurozone reaches a self-sustainable recovery.

Financial markets have already faced similar uncertainty about restrictive monetary policies before. In 2013, the Federal Reserve started tapering, and in 2015 it began raising the target federal funds rate. In those cases, not only the bond markets responded negatively, as expected from the direct link between interest rates and bond prices, but share prices also suffered.

Broadly speaking, markets see the tapering as bad news for stocks, even though they do not seem to agree on the root of their worries. There are usually four main reasons that finance professionals use to justify their fear of tapering or restrictive monetary policy in general:

  • Less money in the market and higher interest rates mean less demand for equities, tighter financing conditions for the firms as well as fewer growth opportunities compared to the current monetary environment;
  • Stock investors switch back from stocks to bonds as the latter become more attractive due to higher interest rates. Thus, stock prices decline;
  • When such an extremely expansionary monetary policy is over, there will be several firms that would not be able to survive in a tight financial, monetary policy;
  • Financial markets are currently obsessed with it. In this case, the behavioural explanation goes beyond the technical matter.

Nevertheless, beyond these market rumours, should investors worry about their stock portfolios?

The answer is not as trivial as many market participants suggest. For instance, consider these three facts as opposed to the previous arguments:

  • The ECB is committed to tightening the monetary policy when the European economy improves, and it reaches self-sustainable conditions. In practice, this translates into higher growth opportunities for the firms as well as a healthy inflation rate (which supports the debt burden) and labour market. It is hard to argue that these are not favourable conditions for the stock markets.
  • Research shows that bonds investors are mainly clustered. In other words, they are not prone to switch from one class of bonds with a particular duration to a different duration following shifts in interest rates. This dynamic is probably due to the nature of bond investing, which is widely driven by immunisation and hedging purposes. Such a consideration makes it even harder to picture a switch from bonds to stocks based on a change in yields.
  • The gradual and carefully monitored shift from one monetary regime to another should ensure a smooth transition, where firms could adapt their business models to the new financial realities.

In fact, the performance of equity portfolios will probably be mixed and – excluding “apocalyptic” scenarios – not as bad as pictured by “tapering-phobic” investors.

Indeed, as far as asset managers set up the equity portfolios to exploit the expansionary business cycle proactively, they should not worry about tapering. The investment in solid companies that have the highest benefit from the healthier economy could effectively hedge the tapering risk.

Conclusion

In the end, although sometimes the market seems terrified about even the word “tapering,” restrictive monetary policies do not foresee a weak economic and financial outlook. In fact, if investors trust the independent and competent role of the ECB, they mean exactly the opposite. Furthermore, monetary policies – being closely related to the business cycle – are quite predictable, thereby enabling investors to rebalance their portfolios on time.

Maybe it is the time that equity investors clear rumors-based fears from their minds, build fact-based portfolios, seat back and start enjoying Mr Draghi’s press conferences independently of their outcome. Differently, there will probably be plenty of opportunities for research-based investors to exploit such a misjudgement.

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