Change in monetary policy is on the way

The summer of 2013 produced some ominous portents for equity investors as merger and acquisition (M&A) activity returned to the headlines.

In September, the American firm Verizon Communications confirmed its intention to buy Vodafone out of their American wireless joint venture. The same week Microsoft announced it would buy Nokia’s mobile phone handset business.

Such deal-making is reminiscent of the heady days of the internet technology bubble – when Time Warner’s infamous coming together with AOL led to the biggest corporate loss in history – or the rash of mergers and acquisitions before the financial crisis of 2008.

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As a barometer of sentiment, this could suggest that the current revival in economic activity might not have too far left to progress. With the accompanying equity market rally already in its fifth year, it makes sense to look for other signs that the end may be nigh.

Investors may, for example, fear that rising interest rates spell the end of rising equities. Interest rates were rising in 2000 while the FTSE index of UK stocks reached an all-time high – a record that has lasted for more than a decade. Interest rates were rising again in 2007, just before the queues started building outside branches of Northern Rock. Interest rates, however, remain grounded for now. Indeed the UK’s highest-profile summer signing, Mark Carney, has attempted to convince investors that interest rates will remain at their current all-time low throughout 2014 and beyond.

Interest rates notwithstanding, a big change in monetary policy still seems to be under way. After many years and various implementations, America’s Federal Open Markets Committee, which sets monetary policy in the US, has expressed a desire to desist from quantitative easing – a policy the UK has already shelved.

Quantitative easing (QE) is the policy tool by which new money is printed to support bond markets. It has supported the US economy since 2009 and the prospect of its end saw bonds perform poorly over the summer, holding back equity markets – even though the Fed surprised investors at its September policy meeting by giving QE a stay of execution.

The relationship between bonds and equities was observed by the US Federal Reserve in 1997, when the chairman, Alan Greenspan, referred to it in testimony to Congress. He lamented the increase in stock prices and the fact that they appeared to only be justified by expectations of higher earnings many years into the future.

With equities having failed to reflect the strength of bonds over recent years, it seems a stretch to assume they will share all of their pain as quantitative easing is withdrawn, especially as, for the time being, monetary policy should stay quite loose. With the outlook for inflation restrained by weak wage growth, stable energy prices and technology-driven productivity enhancements, there is potential for a prolonged upswing.

Guy Foster is head of portfolio strategy at Brewin Dolphin