Watch out for the canaries in the coalmine

Markets are now wrestling with fears that economic and corporate profits growth will disappoint and do so just at a time when the US Federal Reserve is removing the safety net enjoyed by holders of risk assets for most of the last five years. Fed Chair Janet Yellen is expected to confirm on 28-29 October that the American central bank is cutting its monthly quantitative easing (QE) programme to zero and the markets are already fretting about growth, even deflation, three weeks before the big decision.

Whether the timing is coincidental or not remains to be seen, although regular readers will remember this chart below, which shows how the US equity market had previous form when it came to rolling over upon the conclusion of a Federal Reserve QE scheme.

How the S&P 500 has responded to prior Federal Reserve policy initiatives

Source: Thomson Reuters Datastream, AJ Bell Research

The link is made even clearer by a study of the size of the Fed's balance sheet in relation to the S&P 500 benchmark index.

The Fed's balance sheet expansion (thanks to QE) looks to correlate with the S&P 500

Source: Thomson Reuters Datastream, AJ Bell Research

Tighter monetary policy does not mean asset valuations have to fall immediately, as the events of 1994 and 2004 evidence, when the Fed last commenced upon a new cycle. On the first occasion equities peaked in 2000, albeit via nasty wobbles in 1994 and 1998, and then 2007 respectively. And remember the Fed is still promising interest rates will remain low for a “considerable time” once QE ends, even if the plan is to take the headline Fed Funds rate to 1.75% by the end of 2015, up from 0.25% now.

Given that the minutes for the September meeting of the Federal Open Markets Committee reveal how the panel agonised over whether to keep the “considerable time” phrase or not, there is every chance to US central bank will look to refine its policy as events unfold. It would not be the biggest shock were the Fed to hold off from tightening policy further in the event of any market correction or dislocation and this may be why US Treasury yields are grinding lower, as debt investors contemplate a pause in the central bank's route to more 'normal' interest rates.

US Treasury yields are moving lower again

Source: Thomson Reuters Datastream

Sing, little birdies

Whether the NPV calculation is too esoteric for investors' tastes or not, the fact of the matter is the markets do seem nervous about an end to QE. A timely report from Bank of America Merrill Lynch's investment bank flags four indicators which clients can use to judge sentiment and whether it is turning for the better or the worse.

The research is entitled [ITAL] Four Canaries in the Coalmine Just Died [END] and this hardly cheery summary tells advisers and clients clearly what the bank's angle is, but the four themes will thankfully be familiar to regular readers.

The first is commodity prices. The chart below illustrates the Bloomberg Commodities Index, which tracks 22 commodities via the futures markets.

The Bloomberg Commodities Index stands at a five-year low

Source: Thomson Reuters Datastream

The second is is emerging market equities, as benchmarked by the MSCI Emerging Markets index, which is dollar denominated. Note how emerging markets are lagging developed ones, a trend only seen three times in the last decade. Two of those were 2007 and 2011, when markets fell on a global basis, and the other 2013 after the first taper tantrum when risk appetite temporarily waned.

Emerging equity markets are lagging developed ones

Source: Thomson Reuters Datastream

The third is high yield, or junk, debt. This chart shows two US US-listed exchange-traded funds (ETFs) which track the American junk markets. The SPDR Barclays High Yield Bond ETF carries the ticker JNK:NYSE and the iShares iBoxx $ High Yield Corporate Bond ETF comes under the ticker HYG:NYSE.

Junk debt markets are showing some signs of concern

Source: Thomson Reuters Datastream

The fourth and final canary is the small cap arena. Here in the UK, the FTSE Small Cap and FTSE Aim All Share have trailed the FTSE 100 since March while in the USA the Russell 2000 has faltered even as the Dow Jones Industrials and S&P 500 have made fresh highs.

Small caps are underperforming large caps

Source: Thomson Reuters Datastream

If these four indicators start to stabilise, or even rally, then all well and good. If not, we could be on for our first 10% correction in developed equity markets since summer 2011, at the very least. Chair Yellen now has the floor and markets will await her next pronouncements in late October.

Russ Mould, AJ Bell Investment Director.