7. The end of free money in stock markets

Author

Luke Templeman

Macro Strategist

+44(20)754-10130

luke.templeman@db.com

www.dbresearch.com

Deutsche Bank Research Management
Stefan Schneider

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“Will the stock market crash in 2022 as the Fed tapers and likely raises rates?” While many investors fret over this question, the forgotten theme that may accompany the end of free money is not whether stock markets will crash. Rather, it is how investors may be forced, for the first time in a decade, to consider how the end of free money may reorder equity markets on the inside.

The end of stimulus is certain to slow the money flow into equity markets. And if rising interest rates push bond yields higher, investors will have options elsewhere in bond markets and other rate-sensitive investments that have been ignored in recent years. As investments aside from equities become more appealing, frustrated active asset managers may finally witness the return of fundamental investing.

Equity markets will be shocked by the return of fundamentals. After all, in the era of free money, many frustrated ‘value’ managers have given up. The following charts show that as markets recovered from the financial crisis, traditional ‘value’ investing became very difficult.

The reason for the underperformance of ‘value’ is not simply explained by the outperformance of technology ‘growth’ stocks. It is also because the financial crisis catalysed the era of super-cheap money. A significant proportion of this poured into equity markets, much through passive funds which bought the index. As a result, all stocks began to move in similar ways regardless of the profitability of the underlying companies. The following chart shows that between the 2008 financial crisis and covid, the dispersion (or spread) of stock returns disconnected from the dispersion of returns on equity. In other words, even though corporate profits were more different, their stock prices remained similar.

Since covid, stock markets have flirted with the idea of once again discriminating between companies with strong and weak profitability. But the stimulus-fuelled rally has largely ended that. Investors are, once again, simply throwing their money at the entire stock market, particularly in passive funds.

In 2022, as equity markets lose the flood of money that has propped up all stocks over the last decade, investors may be forced to become more discerning. There are signs this is beginning to happen. Postcovid, the dispersion of returns is higher than it has been in almost a decade.

Accelerating the return of fundamentalism could be a tightening in business conditions. Wage pressure, exposure to ESG issues, and the Biden administration’s desire to increase competition, will likely have a disproportionate effect on poor quality companies that investors have hitherto propped up. That will further highlight the gap to market values and widen the differences between companies.

None of this means overall equity markets will crash. Rather, it may lead to a reordering within equity markets as we witness the return of fundamental value investing. Finally, active managers may be back in vogue.

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