We are past the end of the beginning of QE, but still at the beginning of the end.

Last Wednesday was the fifth anniversary of European Central Bank President Mario Draghi’s promise to do “whatever it takes” to preserve the euro.

“And believe me, it will be enough,” he assured us. These were self-consciously Churchillian words, fit for an impending disaster in Europe.

That’s one reason why I thought of them last weekend, as I watched the summer blockbuster treatment of the evacuation of Dunkirk. While it cannot really compare to the greatest retreat in military history, Draghi and the rest of the world’s top central bankers are about to begin the biggest retreat in financial history.

Operation October?

There is more than $13 trillion worth of Federal Reserve, ECB, Bank of England and Bank of Japan balance-sheet liquidity in the economy, a large body of which will be shipped out again.

Last week we got confirmation that the Fed will lead the retreat “relatively soon.” The consensus is for October. It looks likely that we are living within weeks of this remarkable cycle’s point of “peak QE.”

That, together with the IMF’s recognition last week that there is now “no question mark over the world economy’s gain in momentum,” makes this summer feel like a real turning of the tide for financial markets.

What might this mean for equities in particular?

An Immense Undertaking

There is little doubt that riskier assets have been buoyed by this central bank liquidity and that we should expect its withdrawal to create some waves of volatility. Ultimately this will be a welcome development, but given the extraordinarily long period of very low market volatility we have been experiencing, it is worth remembering what an immense undertaking it will be, and that shocks, setbacks and surprises are all but inevitable.

Part of the problem is that markets, being the forecasting and discounting machines that they are, have been anticipating this central bank retreat for some time already.

Volatility is low not only because Fed forward guidance has been clear and steady, but because a weaker dollar, cheaper oil and the global economic momentum heralded by the IMF have been supporting a substantial upturn in earnings. In addition, stock prices have started moving much more in line with their fundamentals, with much less correlation with one another.

Surprises Can Come on the Upside or the Downside

Single-stock volatility has been fairly healthy. In fact, when a company beats earnings, an important drug trial fails or a social media giant lowers its subscriber growth estimates, its stock can be up or down 5%, 10% or 15% on the day. But those moves are very idiosyncratic, with little contagion through the broader market.

This lack of cross-correlation keeps a lid on index-level volatility—but that can evaporate quickly if there are external surprises, such as one of the central banks moving rates or its balance sheet in an unexpected way.

Moreover, as we have argued elsewhere, those surprises can be on the upside as well as on the downside. With the likely failure of the Trump administration’s health care initiative, Washington may be about to pivot to tax policy. We do not expect anything worthy of the name “reform,” but we think we will see a modest corporate tax reduction and repatriation deal. That would help boost U.S. corporate earnings, especially for small-cap companies that typically have higher tax rates.

The Beginning of the End

The evacuation of Dunkirk was a major turning point in the Second World War. And yet two years and some important victories later, Winston Churchill still sounded a note of caution: “This is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.”

Our subdued equity markets are behaving as though there is little change immediately ahead of us. In reality, we are probably past the end of the beginning of QE, but still only at the beginning of the end. When markets are reminded of that reality, as they inevitably will be, the current stillness is likely to be disrupted.

In Case You Missed It

  • U.S. Existing Home Sales:  -1.8% to SAAR of 5.52 million units in June
  • Eurozone Purchasing Manager Index:  -0.5 to 55.8 in July
  • Case-Shiller Home Prices Index:  May home prices increased 0.8% month-over-month and increased 5.7% year-over-year (NSA); +0.1% month-over-month (SA)
  • U.S. Consumer Confidence:  +3.8 to 121.1 in June
  • U.S. New Home Sales:  +0.8% to SAAR of 610,000 units in June
  • Federal Open Market Committee Meeting:  Federal Reserve left interest rates steady and reiterated its intention to start shrinking its balance sheet as soon as September
  • U.S. Durable Goods Orders:  +6.5% in June (excluding transportation, durable goods orders increased 0.17%)
  • U.S. 2Q GDP (First Estimate):  +2.6% annualized rate

What to Watch For

  • Monday, 7/31:
    • Eurozone Consumer Price Index
  • Tuesday, 8/1:
    • U.S. Personal Income & Outlays
    • ISM Manufacturing Index
  • Thursday, 8/3:
    • ISM Non-Manufacturing Index
  • Friday, 8/4:
    • U.S. Employment Report

– Andrew White, Investment Strategy Group

Statistics on the Current State of the Market – as of July 28, 2017

Market Index WTD MTD YTD
Equity      
S&P 500 Index 0.0% 2.1% 11.7%
Russell 1000 Index 0.0% 2.1% 11.5%
Russell 1000 Growth Index -0.3% 3.0% 17.4%
Russell 1000 Value Index 0.2% 1.1% 5.9%
Russell 2000 Index -0.4% 1.0% 6.1%
MSCI World Index 0.1% 2.4% 13.7%
MSCI EAFE Index 0.2% 2.6% 17.2%
MSCI Emerging Markets Index 0.3% 5.7% 25.4%
STOXX Europe 600 0.3% 2.8% 18.9%
FTSE 100 Index -1.1% 0.8% 5.5%
TOPIX -0.5% 0.6% 8.0%
CSI 300 Index -0.1% 2.4% 14.4%
Fixed Income & Currency      
Citigroup 2-Year Treasury Index 0.0% 0.2% 0.5%
Citigroup 10-Year Treasury Index -0.4% 0.3% 2.4%
Bloomberg Barclays Municipal Bond Index -0.1% 0.8% 4.4%
Bloomberg Barclays US Aggregate Bond Index -0.2% 0.4% 2.7%
Bloomberg Barclays Global Aggregate Index 0.1% 1.5% 6.0%
S&P/LSTA U.S. Leveraged Loan 100 Index 0.2% 0.7% 2.1%
BofA Merrill Lynch U.S. High Yield Index 0.2% 1.2% 6.1%
BofA Merrill Lynch Global High Yield Index 0.4% 1.6% 8.0%
JP Morgan EMBI Global Diversified Index -0.2% 0.7% 7.0%
JP Morgan GBI-EM Global Diversified Index 0.0% 2.1% 12.7%
U.S. Dollar per British Pounds 1.0% 1.0% 6.2%
U.S. Dollar per Euro 0.8% 3.0% 11.4%
U.S. Dollar per Japanese Yen 0.2% 1.3% 5.1%
Real & Alternative Assets      
Alerian MLP Index 0.8% 1.0% -1.7%
FTSE EPRA/NAREIT North America Index 0.4% 1.1% 2.9%
FTSE EPRA/NAREIT Global Index 0.8% 2.7% 10.1%
Bloomberg Commodity Index 1.8% 2.4% -3.0%
Gold (NYM $/ozt) Continuous Future 1.1% 2.1% 10.1%
Crude Oil (NYM $/bbl) Continuous Future 8.6% 8.0% -7.5%

Source: FactSet, Neuberger Berman.