Policy

Global Markets' Shakeout

June 21st, 2013 | By Nick Sargen

Highlights

  • Worries about possible Fed tapering of quantitative easing (QE) have heightened financial market volatility with U.S. bond yields surging from record lows, emerging market currencies and bonds selling off, and the Japanese stock market plummeting by 20% from its high.
  • The magnitude of these moves may be exaggerated, as investors (and speculators) are exiting "crowded trades." Nonetheless, their direction offers a preview of how markets may fare once the Fed begins to normalize interest rates. While the Fed is not in a hurry to make changes now, Chairman Bernanke indicated that QE could be phased out by mid-2014 if the economy continues to gain traction.
  • Meanwhile, we are maintaining our over-weight position in U.S. equities relative to bonds, and are biased to be underweight duration in bond portfolios.

Heightened Market Volatility

Following a period of relative calm in the first four months of 2013, global markets have turned more volatile since May. The catalyst was Chairman Bernanke's Congressional testimony in mid-May, when he did not rule out the Fed scaling back on its program of buying $85 billion per month of treasuries and mortgage-backed securities by September. While the Chairman indicated such action would be contingent on steady progress on the jobs front, market participants viewed his answer as a sign of what lies in store when the economy gains traction.

The main impact on U.S. financial markets has been a surge in Treasury bond yields of about 70 basis points from record lows. Normally, investment grade and high yield corporate bond yields lag treasuries in sell-offs. This time, however, corporate spreads versus Treasuries have widened. The U.S. stock market has also become choppier of late, ending a 12 month stretch in which it advanced steadily higher.

These developments have reverberated to other parts of the world, as well. The most noticeable example is Japan, where the yen has appreciated against the dollar and the Nikkei has plummeted from its highs by 20%, after surging by 80% following Prime Minister Abe's election. In Europe, the euro has strengthened against the dollar, while yields for sovereign borrowers such as Italy and Spain have widened versus Germany.

Emerging markets have also experienced a fall-out, especially for commodity producers and countries with large trading ties with China. Previously, officials in some of these countries were frustrated with aggressive policy easing in the U.S., as their currencies strengthened considerably when capital flowed into their markets. (According to JPMorgan, a cumulative $300 billion has flowed into EM fixed income funds since the 2008 financial crisis.) More recently, EM markets have experienced net withdrawals, which have pushed up local market interest rates while putting downward pressure on their currencies and equity markets.

One of the issues we are assessing is the extent to which these market moves are short-term, or technical in nature. When the Fed and other central banks expanded their quantitative easing programs, market participants rushed into risk assets such as equities, high yield bonds and emerging market instruments. Now that investors have to weigh the prospect of an eventual scaling back, they have exited some positions. As investors have pulled out funds, these markets have become less liquid. Consequently, some of the market moves of late may be exaggerated.


Tapering versus Tightening

In weighing the implications of Fed tapering, it is important to recognize at the outset that tapering is not the same as a tightening of monetary policy. The reason: The Fed would still be adding to its holdings of securities (and thereby creating additional bank reserves), but the amount of purchases would be scaled back from the current pace of $85 billion per month.

Fed tightening, by comparison, would mean the Fed is a net seller of securities – i.e. its balance sheet and reserves in the banking system would be shrinking. This, in turn, would be accompanied by an increase in short-term interest rates. While market participants and Fed officials do not foresee the Fed raising short-term interest rates until the first half of 2015, bond yields have surged nonetheless, because investors view Fed tapering as being a precursor to overt interest rate hikes.

In a press conference on Wednesday, Chairman Bernanke clarified the Fed's stance by stating that the central bank may start reducing bond purchases later this year and end them in mid-2014 if the economy continues to improve: "If the subsequent data remain broadly aligned with our current expectations for the economy, we will continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around mid-year."

The Fed's latest forecast for 2014 calls for the economy to expand at a 3%-3.5% pace, while the unemployment rate is projected to decline to 6.5%-6.8%. At the same time, the Fed lowered its expectations for inflation, with virtually every indicator showing inflation and inflation expectations to be declining.

It remains to be seen whether the Fed's forecasts will prove to be accurate, as the tendency has been for the Fed's economists to over-state the economy's strength. Consequently, if data does not confirm these expectations or if inflation falls further, the Fed would likely proceed more cautiously. Nonetheless, Fed officials clearly are feeling more confident about the economy now than they did last fall, when they embarked on QE3.


Investment Implications

Weighing these considerations, we are not changing our overall asset allocation for balanced portfolios that is tilted in favor of stocks: We continue to believe stocks will outperform bonds in an environment of rising bond yields. In the wake of the recent large spike in bond yields, our fixed income portfolios currently exceed their duration benchmarks slightly. However, we are inclined to shorten the duration of our bond portfolios over time, as we foresee a trend of higher bond yields in the next few years.