Should You Be Worried About Quantitative Tightening?

On this episode of The Long View, Jeffrey Kleintop, managing director, chief global investment strategist for Charles Schwab & Co, discusses the global economy, recession worries, economic indicators, and more.

Here are a few excerpts from Kleintop’s conversation with Morningstar’s Christine Benz and Jeff Ptak:

Quantitative Tightening

Jeff Ptak: I wanted to shift and talk about quantitative tightening. You wrote a piece recently on quantitative tightening. Before we get into some of the key takeaways, can you maybe refresh listeners on what quantitative tightening means in monetary terms?

Jeffrey Kleintop: There’s a real page-turner, right? I report on QT. So, quantitative tightening—we talked about QE so much, quantitative easing, we just started referring to it as QE. Well get ready for talking about QT. So, QT is just the unwinding of QE, quantitative easing. When central banks reverse their former QE program asset purchases by not reinvesting maturing bonds or even outright selling bonds to reduce the overall size of their balance sheets. Stocks in a way are liquidity reservoirs. So, when there’s a lot of liquidity, because the Fed is buying a lot of bonds and pumping a lot of money into the financial system, stocks rise. They rise on that liquidity. They absorb that liquidity. And the opposite is true as well. When the Fed is then draining liquidity from the markets through quantitative tightening, well, that reservoir dries up and stock valuations tend to come down.

We can refer to this maybe more intuitively as the portfolio rebalancing effect, where investors tend to seek more risk when bond yields are low and they can’t find any value in the bond market, and they tend to reduce their holdings in stocks and other risky assets when QT drives yields higher and makes bonds more attractive. And so, that’s kind of how it works. We’ve seen this in the U.S. We’ve seen this to a lesser degree elsewhere. But it’s hard to draw solid conclusions from this.

We don’t have a lot of experience with QT. It’s a little bit of a roach motel. Like you can check into QE, but it’s real hard to check back out again. And so, we’ve only got a couple of experiences of QT. We had Japan do it in 2006 and 2007. And the U.S. did it from 2017 to 2019. During both periods, stock markets had above-average volatility. They had a peak/trough decline of 19%, so just below the threshold of a bear market. And they ended those periods of QT, the stock market did, right about where it began. So, overall, a flat, volatile period for the overall market. So, difficult to draw hard and fast conclusions from it, but enough to say that I think it is a bit of a drag on the overall market, at least from a valuation perspective.

The Correlation Between Quantitative Easing and S&P 500′s Valuation Multiple

Christine Benz: Your research found a correlation between quantitative easing and the S&P 500′s valuation multiple. Can you explain what you measured there and what implications it could have amid a shrinking Fed balance sheet?

Kleintop: I think there’s this pervasive market view, perspective, myth maybe that the Fed has just driven all the valuation improvement in the markets. And it’s really just all about this liquidity reservoir effect that I talked about. I think it’s important at the margin but isn’t necessarily the only driver of the markets. But certainly, we did see with the Fed’s QE program in 2001 and 2002, we saw a valuation spike. Now, there’s a couple of reasons why valuation spike. The price can go up and the earnings can go down. And earnings certainly fell as we went through that downturn. Not terribly, but they did suffer a pretty big drop. So that alone would push up the price/earnings ratio. But that wasn’t the only factor. Prices went up at the same time. It’s kind of remarkable when you look back at that period, including 2020, and you see stocks bottomed on March 23 of 2020. That was six, seven, eight months, nine months before we had vaccines. That was just at the beginning of the lockdowns. I think a lot of that had to do with the perception that the Fed was going to rapidly shift gears along with other central banks and provide a wave of liquidity to the markets to support valuations. And support the economy and support consumers and businesses. And the market reacted to that. I think that’s often what we see. And this is the opposite scenario where the Fed is trying to pull back from businesses and consumers and the overall markets in terms of liquidity. And it may have a similar effect in dampening the price/earnings multiple.

Stock Volatility Was “A Round Trip to Nowhere”

Ptak: I wanted to go back to quantitative tightening, if I may. And I think you did a really good job of sketching out the other episodes that have taken place. I think you mentioned Japan in 2006 and 2007, the U.S. in 2017 to 2019. Not a big sample, right? We’ve only got like a handful of these to look at. But it does seem that during these periods, stocks became more volatile, but it was like a round trip to nowhere in a sense. They didn’t really move that much as long as you stayed in your seat, so to speak. So, do you feel like that’s the key takeaway for somebody that might otherwise be gripped about fears over quantitative tightening buckle up, but stay in your seat because if history, albeit not a big sample, is a guide, it doesn’t seem that markets pull back dramatically by the time you get through it. Does that seem like a fair way to characterize it or think about it?

Kleintop: It does. I think you want to brace yourself and expect higher volatility. But trying to time that is extremely difficult. I just mentioned the example there of March 23 when markets bottomed in 2020. There was no clear sign that the risk was over or some change by policymakers. Clearly, I think if you pulled anyone that day or week or month, they would have said, no way is the worst over, but it was for the stock market. And that’s the challenge. When we move through these periods, incorporating high volatility and geopolitical developments and political developments and a turnaround in the earnings cycle and so many other factors, is that it’s compelling to try to jump out.

I get the question at events: “Hey, look, things seem so uncertain right now and maybe will be uncertain over the next year. Why don’t I just get out of the market? Cash is yielding 5%. Why don’t I just get out of the stock market right now? You’re telling me it’s going to be volatile. There’s risk. Why don’t I just step aside and pocket that 5%?” And the answer, of course, is because you have to make two decisions. This one’s the easy one. You know what you’re going to get. You’re going to get 5%. At least in the near term. It’s the other decision that’s hard. It’s when do you get back in? And we all have to get back in to get to our financial goals. Very few of us can coast on cash to our retirement goals. And so, we know we’ve got to get back in. We have every trade made at Schwab since 1976. And we know empirically how hard it is to get both sides of that equation right. They get out and they get back in again. Very, very, very few traders or investors get that right. And so, that’s the advice: expect a higher period of volatility, but that perhaps we end this period with a market fairly similar to where it is now. And that will happen when you don’t even realize it, and then you’ll remain on that path toward financial goals.

I can talk about this a lot, but I really think that is an important takeaway from all of this. Rarely do you hear us at Schwab talking about making asset-allocation changes in terms of stocks to cash, stocks to bonds. We tend to think you really want to stick to those long-term goals but be educated and be confident in those decisions that you’re making so that when these developments do occur, you’re prepared mentally and portfolio-wise to absorb them.