The Feds Role Amid a History of ViolenceLearn more about this firm
Benjamin Franklin once observed that the only certainties in life are death and taxes. I would add one more certainty to the list: crisis. Yes, the inevitability of a crisis is right up there with dying and paying your share to Uncle Sam.
That’s not always good for investors because the stock market doesn’t like uncertainty. And last week was a perfect example of the kind of uncertainty that can rattle investors. The crisis in the Middle East exploded as terrorist insurgents began taking over cities in northern Iraq. This crisis has converged with a similar one in Syria, with the same militant group leading both insurgencies. This escalation of violence has created a two-headed monster for the United States.
By Sunday, the United States had announced it was evacuating its embassy in the heavily fortified Green Zone of Baghdad. The Islamist State of Iraq and Syria (ISIS) announced it had executed 1,700 Iraqi soldiers. Meanwhile, the crisis in Ukraine flared up, with pro-Russia insurgents shooting down a Ukrainian military plane, killing 49 troops. Both events threaten to draw America into involvement in both regions—and threaten to unnerve US investors.
In the US political sphere, there was Congressman Eric Cantor’s (R–Va.) surprising loss in the Republican primary. While Cantor’s seat is one of more than 500 seats in the House of Representatives, his defeat is the first ever dealt to a House Majority leader in a primary—and has implications for all of Congress. Most strategists view it as a sign that US politicians will become more polarized and less likely to cooperate going forward, and that Washington may become even less business-friendly. This scenario is troublesome given that we’re set to revisit the debt ceiling in 2015. In other words, another crisis—this one of a political nature—could be brewing.
Still, while crises are often very disturbing and can shatter investor confidence, they typically only have a short-term impact on the stock market. Take the assassination of President John F. Kennedy, an event incredibly unexpected and earth-shattering. Not surprisingly, it sparked nationwide fear among investors, who sent the Dow Jones Industrial Average down 2.8%. But the stock market recovered fairly quickly. The same can be said of 9/11. The terrorist attack of Sept. 11, 2001 was another unfathomable crisis in US history. Despite the enormous death toll and predictions that the stock market would be damaged for years to come, the market recovered relatively quickly.
But these crises have something else in common: The Fed is prepared to support the stock market and, in some cases, has actually provided short-term liquidity and support for long-term economic growth. These Fed actions have provided a level of shock absorbency that has helped stocks rebound rather swiftly.
Indeed, this cushion was part of the Fed’s blueprint. St. Louis Fed economist Christopher Neely wrote in his paper, “The Federal Reserve Responds to Crises: September 11th is Not the First,” that the Fed was created largely to provide liquidity and counter the many bank panics that plagued the 19th century. By design, the Fed has a number of tools at its disposal to provide all the liquidity needed or desired by borrowers and lenders, or to maintain financial market stability.
“… the Fed was created largely to provide liquidity and counter the many bank panics that plagued the 19th century.”
Without question, markets feed off confidence. And the confidence created by the Fed’s willingness to wield these tools set cannot be underestimated. In fact, the Fed cut rates several times in the four months following the 1987 stock-market crash, which was critical to its recovery. As NYU Prof. William Silber explained, “The financial system would have ceased to function were it not for the central bank’s broad interpretation of its responsibilities as the ultimate source of liquidity.”
In the wake of 9/11, the Fed sought to restore confidence and promote liquidity by assuring market participants that, as the lender of last resort, it would provide ample liquidity to money markets. That meant expanded repurchase agreements, liberalized lending terms at its discount window, swap lines for foreign central banks to satisfy liquidity needs in US dollars, and a series of cuts in the fed funds rate and discount rates in the aftermath. These Fed actions were also important in helping to instill confidence in investors. And after the global financial crisis, the Fed took extraordinary measures to not only provide liquidity, but also to drive an economic recovery.
Today’s “helicopter investors” will have trouble tolerating the crises we’re experiencing right now, as we saw last week. Similarly, whatever future crises arise will test their mettle. However, most of these crises are likely to have only a short-term impact on the stock market. Hopefully, investors with a longer time horizon will look past these short-term problems and keep their eyes on meeting long-term goals. If nothing else, maybe they’ll take some comfort in knowing that the Fed is prepared to act if any of these crises reach a fever pitch.
This week’s FOMC meeting and Chair Janet Yellen’s press conference on Wednesday should be reminders of the Fed’s role as a powerful shock absorber for the stock market. While the Fed likely won’t comment on current headline risks because they haven’t yet resulted in disorderly markets, it takes its duties as a stabilizing market force and a lender of last resort seriously.
Kristina Hooper, CFP, CAIA, CIMA, ChFC, is US head of investment and client strategies for Allianz Global Investors. She has a B.A. from Wellesley College, a J.D. from Pace Law and an M.B.A. in finance from NYU, where she was a teaching fellow in macroeconomics.
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