Life after quantitative easing

We are halfway through 2013, and in many ways equity markets are following the same pattern they have set over each of the past four years – since the market turn in 2009. This pattern is one of a strong start to the year, followed by a sharp pullback in confidence as a new risk factor emerged. What set the cat amongst the pigeons in mid-2013 was the announcement by the US Federal Reserve Bank (Fed) on 19 June that it ‘might’ start scaling back its programme of buying up assets from financial institutions – currently $85 billion a month – later this year. This news caused a roller-coaster ride in markets, many of which had come to rely on their monthly ‘liquidity-hit’ courtesy of Ben Bernanke. The general perception was that this announcement represented a market sea change, the biggest since the financial crisis of 2008. In essence, the message was taken as being that the benign conditions of the last decade will no longer apply.

In our opinion, the reaction of investment markets to this statement has been extremely illuminating. Firstly, it has highlighted the extent to which certain financial market participants have become increasingly reliant on the liquidity supplied by the Fed. Or put another way, fundamental analysis mattered far less to these investors than the knowledge that quantitative easing was protecting their decisions through a wall of liquidity. Secondly, and more importantly, it has flushed out a number of asset classes that were the primary beneficiary of these one-way bets. The speed of these reactions has, as always, surprised many investors.

The casualty with the most far-reaching effect was the bond market. Following the Fed’s pronouncements, the benchmark US yields jumped up by more than 80 basis points. The result was that US fixed income investors suffered their worst first half of a year since the bear market of 1994. The Barclays US Aggregate Index, the benchmark for fixed income managers, had returned a negative 2.5% since the start of 2013. More worryingly (for mortgage lending) is that an index of long-dated US treasury bonds has fallen by more than 9% since the start of the year. This move has not come as a surprise to us, and Coronation clients will know that our investment team has for some time spoken about the potential dangers of investing in overvalued developed market bonds.

A most interesting reaction to recent events was that of the gold price, which fell below $1 200 an ounce – thereby falling by a shade under 30% since the start of the year. This price action reflected a capitulation by supposedly longer-term investors, including wealth and pension fund managers, who have been instrumental in fuelling its parabolic rise over the past five years. To give this perspective, the gold price rose from a low of around $750 an ounce in 2008 to a high of $1 800 an ounce in 2011. The scale of the recent shift away from gold by investors has been dramatic. Gold exchange traded funds, an easily accessible and liquid form of gold investment, have sold 20% of their holdings so far this year, while investor positioning in US gold futures and options is the least bullish since 2005 according to the Commodity Futures Trading Commission. Clearly many investors, convinced that the easy monetary conditions prevailing in the US will lead to sharp rises in inflation, have changed their minds. Other commodities also suffered as a result of the prospect of the liquidity tide going out. Copper, always a popular speculative asset, fell sharply by over 11% during the second quarter of 2013.

Developed equity markets were inevitably hit as well. While the Standard & Poor’s Index was up by 6.4% for the quarter at one point, the quarterly gain shrunk to 3% by the quarter end. Emerging market assets also had a tumultuous month during June, with equities falling by 12.7% at the worst point. Emerging market bonds similarly lost over 8% in value at the low point.

In addition to the worries caused by the prospect of an end to the Fed’s asset purchases, liquidity concerns in China caused similarly disruptive influences on investment markets. Global assets took a further hit in the middle of June when a cash crunch emerged in the Chinese banking sector, raising fears of a slowdown in the country that remains the main contributor to global economic growth. The fears related to parallels being drawn between China today and the US in 2008, as China is perceived to be exactly where the US was five years ago. This follows several years of excessive credit growth (the US in 2008; China today), much of it in the shadows of the banking system. During June, China’s financial institutions stopped lending to each other when, on 20 June, interbank interest rates briefly soared to 25%. This crunch seemed horribly reminiscent of the American financial crisis in 2008. However, the key difference to the US is that, whereas in the US the financial system froze because banks refused to lend to each other, China’s credit crunch was induced by the Chinese central bank itself refusing to lend to the banking system. This was the central bank signalling its determination to restrain the reckless growth of credit.

It is our opinion that the end of quantitative easing (although it will be gradual) will be a game changing process – and one that investors should take very seriously. Although some asset types have since stabilised, it is clear that the volatility is not over as investors continue to unwind positions they took to benefit from the Fed’s multi trillion dollar programme of quantitative easing (QE). The whole point of QE was to push investors into riskier assets, thereby propping up markets – and by implication the economy. The Fed kept interest rates low, which meant that investors looked for higher yields wherever they could be found. Commercial real estate and C-grade corporate bonds were in the forefront of this surge. The key point is that the era of central bank imposed stability is coming to an end. That said, winding down the QE programme is going to be more protracted and the lag between reduced asset purchases and an actual increase in interest rates will be longer than the recent panicky response suggested. While this change undoubtedly looks bad for certain asset types, it is by no means the end of the world for stock markets.

The reason that the Fed will be able to taper off more gradually (than recent perceptions) is the benign trade-off between growth and inflation in the US. Growth – while decent – is being capped by spending cuts forced by the sequester-related spending cuts and the effective policy tightening imposed by a rise of nearly 1% in 30-year mortgage rates. That is keeping inflation in check but also disguising the fundamental strength of the US economy, thereby allowing the Fed to keep interest rates lower for longer. Additionally, the twin deficits – budget and trade – are finally under control thanks in part to the shale gas revolution. This improvement in the deficits is stabilising the US dollar, in turn keeping a lid on inflation via lower commodity prices.

At the halfway stage of 2013, leading developed equity markets are down between 5% and 14% from their peaks in May. This is not a bad thing. We believe that the outlook for the US economy is as good as we have seen it for the past 20 years and that this is reflected in the relatively modest up tick in the VIX volatility ‘fear gauge’ during the recent correction. The US is in a relative sweet spot. Consumer confidence has reached levels not seen since before the financial crisis, housing continues to strengthen and unemployment is slowly but surely falling. Inevitably there are the nay sayers who will point to a weak (1.8%) growth rate in the first quarter of 2013 and the slow rate of job gains. We continue to believe that growth in the US will ratchet up rather than down.

In Japan it is a different story, but in the short term the market outcome should look very similar. Tokyo is even more policy driven than the US, with the first two of Prime Minister Abe’s arrows – monetary and fiscal policy – combining to boost output to a possible 4% in 2013. That should be enough to restart the rally in the Nikkei Index after the recent shake-out, and the second half of the year could turn out pretty well. Whether this can be translated into a sustainable bull market depends on whether the third arrow – economic reform – can hit its target. With a stagnant workforce unlikely to be boosted by either more female participation or immigration, it is all down to productivity gains, and the difficult decisions needed to make these a reality will test Japan’s willingness to embrace change. When it comes to reinventing itself Japan has done it before, but it has been many years since it has demonstrated the tough renewal that is needed. July’s upper house elections will retard any progress in the very short term.

China does remain a risk. As mentioned above, the state is trying in fits and starts to clamp down on a credit bubble by forcing banks to slow down their lending. If successful, it could be a step toward a more sustainable economic model, which is desperately needed now that growth is slowing. It should be remembered that China has an extraordinarily high savings rate and, unlike the US before 2008, the country as a whole is living well within its means. Its banks are subject to very stringent rules; their loans cannot exceed 75% of their deposits and, unlike many other countries, China is already implementing the global prescriptions on bank capital known as Basel III. Letting interbank rates spike to 25% was a brutally effective way for the authorities to punish overstretched lenders. It was, however, a necessary response to the ongoing rumours regarding bank defaults and ATMs running out of cash. While hard to predict with massive conviction, China is a resilient economy that has grown its way out of its problems in the past. However, it must not allow the shadow banking bubble to expand any further.

There are, in our opinion, other benefits to the tapering off of the QE programme. With risk-taking set to become less attractive and therefore likely to fall, we think that so too should correlations between asset classes. For the past few decades, there has been a tendency for markets to move in concert; emerging markets would rise and fall together, as would developed nations and various industrial sectors. Things were either up or down. Statistics now show that these correlations are breaking down, requiring investors to focus on the stories of individual nations and companies. Europe, for example, looks set to stay in recession or flat for a number of years, whereas the US economy is clearly trending up. In emerging markets, export-led economies made good sense when the West was gorging itself on debt-fuelled consumption; but not so today in the post-crisis world. Some emerging markets will make the transition to domestic consumption-led economies and do well – China for example. Others, such as Brazil which have used the commodity boom to put off reform, face a tougher time.

Looking ahead, we repeat our positive positioning that international equity markets will, despite periodic setbacks, continue to move steadily upwards. What gives us continued conviction is the fact that most investors remain deeply suspicious of equities. Statistics suggest that since equity markets bottomed in 2009, a massive amount of investor capital has flowed out of global equity funds. This distrust will ultimately reverse. Of equal importance is our belief that it will be a better time for stock pickers around the world. With the MSCI Emerging Markets Index down 19% since the start of the year, and emerging market valuations below their long-term averages, a number of countries and companies are looking attractive.

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The Allan Gray-Orbis Global Equity Feeder Fund remains fully invested in global equities. The objective of the Fund is to outperform the FTSE World Index at no greater-than average risk of loss in its sector.