July 2013 - Easy Money: The Beginning of the End
The first part of 2013 is now behind us. Volatility in financial markets has increased materially. The month of June will be remembered as one where bond markets experienced historic levels of redemptions and losses, triggered by a hawkish Bernanke, announcing on June 18th his intention to ‘taper’ Fed purchases later this year and stop it altogether by mid-2014. The dramatic increase in Treasury yields over the past 2-months has been classified as the 4th greatest turning point in bond yields in the past 100 years.
Extremely loose Federal Reserve policy has been the principal driver of asset returns for the past 5 years. We believe that this liquidity withdrawal will not be painless and will create higher volatility. Whatever the exact timing of the Fed’s tapering of bond purchases, the taboo has now been broken and we must warm-up to the idea that the easymoney regime is coming to an end.
The best way to think about how this regime change is going to affect asset classes is to analyze those asset classes which have benefitted the most from the Quantitative Easing policy of the last 5-years and from the subsequent aggressive ‘search-for-yield’ it has unleashed on markets. What naturally comes to mind are long-duration and lower quality bonds, particularly those issued by Emerging Market sovereigns with high external deficits or companies with high leverage. Gold, which used to be a play on inflation and expansive central bank balance sheets, will remain under pressure, despite the very large repricing seen in June (-28% year-to-date).
Markets rebounded last week on a realization that investors may have overreacted to the June Fed meeting as several Fed members have stressed that tapering remains ‘data-dependent’ and that it does not mean actual tightening of financial conditions, it just means reducing the pace. Besides that, last week we received a big downward revision of US Q1 GDP (1,8% vs 2,4% expected). The Fed's forecast assumes this growth rate will nearly double in the second part of the year, which appears a rather optimistic call. Our view is that Fed tapering will only start in December of this year and that the purchase program will only end in December 2014. We would also watch out for rapidly rising mortgage rates as they are a risk to the US housing recovery and may prompt Bernanke to intervene to contain the rise, verbally at least.
How do we position ourselves for this transition period into a lower-liquidity world ?
1) The best strategy of defense against the end to easy money is to have an increased weight of equities in our portfolio. Equities still offer the highest risk premium amongst other asset classes and have much less benefitted from the ‘search for yield’ dynamics. Moreover, they will benefit from the more positive growth/inflation mix that the Fed is forecasting in order to reduce its liquidity program. Our preferred sectors are US consumer goods, pharma, telecom and homebuilders. European stocks look attractive to us as the region is showing signs of getting out of the recession and valuations are still historically cheap.
2) We have significantly reduced our allocation to bonds, in particular to Emerging market bonds as they were by far the largest beneficiaries of central bank liquidity. Credit, not duration, is what interests us at this point: we therefore look to remain invested in short-duration and higher quality bonds (BBBs and BBs), issued by companies with solid fundamentals, low refinancing risk and acceptable leverage. The outflows in the bonds asset class have been the highest on record. This may not be over. One would have to look past the volatility in this asset class and look to fundamental value in credit spreads vs. current default rates, which we believe still constitute a good value proposition.
3) We continue to avoid commodity markets in our asset allocation as they are very dependent on Emerging market growth, Chinese in particular. China’s disruptive funding markets in June (Shangai Libor rates reaching above 5%) have certainly not helped sentiment and this underlines the risks linked to China’s real-estate bubble. Generally speaking, we prefer to invest in energy markets (Oil) as opposed to metals as Emerging Markets GDP growth momentum is stalling and oil markets are naturally defended by a proactive OPEC.
4) In our Foreign Exchange allocation we believe that a gradual and orderly tapering of the Fed’s QE program should be US Dollar-positive. The shale gas revolution and the subsequent energy independence the US will achieve are important factors which should underpin the US-Dollar going forward. Moreover, the USD will also benefit from ongoing currency wars and central banks acting forcefully to weaken their currencies (JPY, AUD, BRL CHF, EURO, ILS, etc).
A high degree of differentiation across risk markets is likely to persist for the next few months as we transition into a ‘new normal’. That is why a proper regional and sector selection strategy, combined with rigorous riskmanagement should remain the decisive factor for investment performance.