Why stock market investors shouldn't sweat a shrinking Fed balance sheet – MarketWatch

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Corporate earnings, not central banks, are the real driver of the global equity rally, so there’s no point losing sleep over the imminently expected unwinding of the Federal Reserve’s balance sheet, according to Jeffrey Kleintop, chief global investment strategist at Charles Schwab.

The Fed is widely expected to begin slowly unwinding the $4.5 trillion portfolio of bonds and other assets it accumulated via its asset purchase program in the wake of the financial crisis. The aggressive purchasing program was the centerpiece of the Fed’s quantitative easing program, which was designed to drive down long-term interest rates, boost investor appetite for risky assets, promote investment and boost the economy.

The Fed ended the bond-buying program in 2014, but continued to reinvest maturing bonds to keep the balance sheet from shrinking.

Read: Fed’s balance-sheet unwind will be moment of truth for financial markets

Now, after four rate increases, and with stocks at record highs, many investors are fretting whether the unwinding of the balance sheet will pressure the stock market.

The plan to reduce the balance sheet will start with only $10 billion a month initially, which would be then increased by $10 billion every quarter, up to a maximum of $50 billion a month. At this pace it will take years before a significant dent is made in the balance sheet.

Meanwhile, some economists argued that even incremental selling could be easily absorbed by the markets.

Still, there are fears that quantitative tightening will inevitably pressure stocks and other assets, just as quantitative easing provided support. The benchmark S&P 500 index SPX, +0.14%  of large-cap stocks, the best proxy for the U.S. equity market, has posted a cumulative return of nearly 240% since the Fed first began purchases in November 2008.

Kleintop agrees that the Fed’s quantitative easing program boosted stocks, but he argued that the relationship “ended about a year ago as earnings lifted stock prices while the Fed’s balance sheet growth stalled.”

“This divergence reveals that it is more likely to have been the rise in earnings, rather than Fed easing, that supported the rise in stocks,” Kleintop said in a note to investors.

Kleintop said that earnings drove equity markets not only in the U.S. but in Japan and Europe. “Since the financial crisis ended earnings growth is largely independent of central bank actions,” he said. In a chart below he shows the global index tracking earnings growth closely over the past two years.

Kleintop says there is no need to worry about the shrinking of the Fed balance sheet or tapering by the European Central Bank. He also cautions investors favoring Japanese equities expecting continued supports by the Bank of Japan.

“The truth is easily revealed that the link between central bank balance sheets and the stock market is like the emperor’s new clothes: there is nothing there,” he said.

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