When will the Fed stop propping up the US stockmarket?

US stocks have staged a remarkable rally, fuelled by the Federal Reserve’s low interest rate policy. John Stepek looks at what would make the Fed change its mind, and what to do in the meantime.


The Federal Reserve's low interest rate policy has fuelledthe US stockmarket rally

This Thursday will mark a special anniversary for the S&P 500.

Assuming there isn't a bear market between now and then (which seems unlikely), then this market rally will become the second-longest on record, according to Bank of America Merrill Lynch.

Is it on its last legs? Or can the good times continue to roll?

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The conundrum that isn't really a conundrum

The longest, reports the Financial Times, was the bull market from the bottom in 1987 to the top in 2000. To match that one, we'd have a fair way to go all the way until June 2021.

If you're wondering about the grim start to 2016 which saw many markets dip into bear territory briefly well, that doesn't count. The S&P 500 was one of the stockmarket that avoided ending up in the bear zone.

So can it continue?

Obviously there's a bit of a conundrum here. Global bond markets are pricing in a world of painfully low returns for years into the future.

And on the corporate profits side, companies are finding it harder and harder to meet stockmarket expectations. For example, in the UK, corporate profit warnings are running at their highest rate since the financial crisis, according to the FT.

How do we square these circles? A long-lasting bull market in stocks on the one hand; a bond market that is pricing in an incredibly grim economic future on the other.

The answer to the conundrum is actually fairly straightforward. It's largely about central banks. It doesn't really matter what you believe if there's a large, price-insensitive buyer with infinite funds sitting in one corner of the market, then it makes sense that the assets it craves are priced at levels which make little logical sense.

Meanwhile, the equity markets enjoy the knock-on effect of all that money flooding into another corner of the asset markets.

This isn't necessarily to say that this entire rally is solely due to quantitative easing and central bank intervention. There's no doubt that the global economy and financial system are in a better place than they were in the throes of the crisis in 2008 (not that this is saying much).

But the longevity and other weirder aspects of both the bond and equity rally are easily explained by the sheer level of historic and ongoing intervention by central banks.

And I think if you're wondering about the longevity of the S&P's rally well, this bull market was ignited by the US Federal Reserve, and I suspect that it is likely to continue for as long as people believe that the Fed will prop it up.

For example, the main factor that saved the bull market this year was the Fed's decision to put a halt on raising interest rates for the time being. The Fed has also made it clear (in a "nudge, nudge, wink, wink" sort of way) that it is in no hurry to raise interest rates.

The effect has been to weaken the US dollar (which was one factor panicking markets earlier this year) and in turn, help to boost everything from commodities to emerging markets as a result.

What would it take to make the Fed raise rates?

As we've said before on many occasions, the Fed sees the S&P 500 (and stockmarkets generally) as the "feel-good" asset. The one that the man in the street looks at to check if things are going his way. If stocks are going up, life is fine, there's no need to worry too much about money, and "animal spirits" will be suitably vivacious.

It's the same with house prices in the UK. If an Englishman's home is earning more each year than he does, he'll sleep easy at night, spend easy when he goes shopping, and vote for the incumbent government.

So the point is, no one in authority in the US is particularly keen for the US stockmarket to endure a bear market. So if it's in their power to prevent it, they will.

Which takes us back to the interesting question: what could force the Fed to put aside its concern for the stockmarket, and take the sort of tough decisions that might send it lower?

And once again, I have to come back to the view that until inflation reaches the point where the Fed can't just ignore it or shrug it off, it'll be happy to keep rates at a level where they don't rattle markets.

In other words, the Fed will deliberately remain well "behind the curve" until such time as inflation, rather than deflation, is quite obviously the enemy and the biggest threat to investors.

That could be a while in coming.

Of course, there are likely to be plenty of wobbles in the meantime. And that's one reason why I'd still tend to favour markets that are benefiting from direct money printing (such as Japan and Europe). And in the meantime, make sure your portfolio would be ready to cope with "surprise" inflation.

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.