The Ripple Effect

This article was featured in The Georgia Association of Public Plan Trustees's Newsletter.

In March 2022, the U.S. Federal Reserve System began a campaign of interest rate increases to quell inflation. These interest rate increases apply only to lending and borrowing rates in the United States. Still, in an interconnected global economy, monetary policy enacted by individual central banks can impact global equity markets.

We saw this during the 2013 Taper Tantrum and the 1994 Bond Market Crash. For those unfamiliar, in the mid-1990s, the U.S. Federal Reserve (the Fed) began raising interest rates to preemptively curb inflation. This unexpected tightening caught many investors off-guard, and the bond market experienced a crash. The impact was felt globally, causing losses in both equity and bond markets as investors grappled with the prospect of higher interest rates and their potential effects on economic growth and corporate earnings.

Interest rate increases are an example of monetary policy, a tool central banks use to manage economic conditions and stabilize their financial systems. Monetary policy actions, such as cutting interest rates or quantitative easing, have often stimulated global equity markets by lowering borrowing costs, boosting investor sentiment, and encouraging risk-taking behavior.

Today, I’d like to explain how the three types of monetary policy can shape and influence equity markets in today's dynamic financial landscape.

Interest Rates: The Pivot Point

Interest rates play a pivotal role in monetary policy. Central banks adjust interest rates to stimulate or cool economic growth. When interest rates are lowered, borrowing costs decrease, encouraging businesses to invest and consumers to spend. This can have a positive effect on equity markets, as companies benefit from improved access to capital and increased consumer demand. Conversely, rising interest rates can dampen equity markets, as higher borrowing costs may reduce corporate profitability and consumer spending, all else equal.

Figure 1‍

In early 2019, the Fed shifted from a tightening to an easing stance due to concerns about slowing global growth. Pausing interest rate hikes reassured investors, leading to a rally in stock markets as lower borrowing costs andexpectations of continued monetary support boosted sentiment and encouragedrisk-taking behavior.

Quantitative Easing: Boosting Liquidity

Quantitative easing (QE) is another tool used by central banks. Through QE, central banks purchase government bonds and other securities, injecting liquidity into the financial system. Increased liquidity can positively impact equity markets by supporting higher valuations and enhancing investor sentiment. Overall, QE can provide a tailwind for equity markets by lowering long-term interest rates and stimulating economic activity. However, the withdrawal or tapering of QE programs can also have significant implications for equity markets, potentially leading to increased volatility and adjustments in asset prices.

You might recall that, in 2008, during the global financial crisis, central banks, including the Fed and the Bank of England, implemented QE programs by purchasing government bonds and other assets. These actions injected liquidity into the financial system, reduced borrowing costs, and boosted investor sentiment. As a result, stock markets responded positively, experiencing significant rallies as investors sought higher returns in equities due to the low-interest rate environment created by QE.

Forward Guidance: Guiding Investor Expectations

Forward guidance is a communication tool central banks employ to guide market expectations regarding future monetary policy actions. By verbally clarifying the central bank's intended course of action, forward guidance aims to influence market behavior and investor sentiment. Forward guidance can substantially impact equity markets as it helps shape expectations regarding interest rates and policy stances. Clarity and consistency in forward guidance can provide stability and boost confidence in equity markets, while unexpected shifts in guidance can lead to market volatility and adjustments in asset prices.

Figure 2

In 2013, the Fed indicated it would reduce the number of assets purchased monthly while economic conditions were favorable. Known as"taper talk," this caused market volatility as investors reacted to the potential reduction in monetary stimulus, leading to stock market declines.

Unintended Consequences and Challenges

While monetary policy tools can positively affect equity markets, they can also give rise to unintended consequences and challenges. Excessive monetary stimulus can inflate asset prices, potentially leading to bubbles and misallocations of capital. Additionally, the dependency of equity markets on central bank actions can create a level of market sensitivity and vulnerability to policy changes, making markets more reactive to monetary policy developments.

One historical example of unintended consequences of excessive monetary stimulus can be observed in the housing bubble and subsequent financial crisis in the mid-2000s. In response to economic slowdowns, central banks lowered interest rates and implemented accommodative monetary policies, encouraging borrowing and investment. However, this led to excessive risk-taking in the housing market, with lax lending standards and the proliferation of subprime mortgages. The resulting housing bubble eventually burst, triggering a severe financial crisis and global recession. The unintended consequence of the excessive monetary stimulus was the amplification of systemic risks, highlighting the importance of monitoring and addressing potential economic imbalances.

In Closing

While monetary policy can provide tailwinds for equity markets, it also brings challenges and unintended consequences. It’s important to note that while monetary policy can have a significant influence on the equity market, it is just one of many factors affecting financial asset prices. Other factors, such as economic conditions, corporate earnings, geopolitical events, and global trade dynamics also play crucial roles in determining equity market performance. We encourage investors to remain vigilant, understand the potential risks, and adopt a well-diversified portfolio approach to mitigate the impact of policy changes.

At Balentine, we build custom strategies for our clients, creating a well-diversified portfolio based on our data-driven investment model while accommodating each client’s specific risk tolerance, goals, and tax situation. If you’re interested in learning more about our services, one of our relationship managers would be happy to connect with you.

By staying informed about the evolving landscape of monetary policy and its impact on equity markets, investors can navigate the complexities of the financial world, make informed decisions, and position themselves to capture opportunities while managing risks effectively.