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October 2013 - No Tapering until 2014 is bullish for markets



As this newsletter is coming to press, US federal agencies are shutting down for an indefinite period, raising fears that a political stalemate in Washington over a short-term budget might not be resolved in time to extend the nation's borrowing limit . We are in a so-called ‘government shutdown’ situation, not seen since 17-years ago under the Clinton adminsitration. Financial markets however, are not particulary shaken by such political posturing this time around. At the time of writing the market impact from this news on US Treasury bonds, US dollar and S&P Index has been relatively muted. The shutdown is unlikely to last long. In the past, government shutdowns typically lasted a few days, with the most being 21 days in 1995.


More relevant for the markets is the debt ceiling showdown on October 17th. We are of the opinion that a last-minute deal will be struck by both parties, in the same way that the fiscal cliff deal was finalized at the very last minute on Dec 31st 2012.


Away from the US budget and politics, financial markets are still digesting the volte-face by the Federal Reserve on September 19th, when it announced it’s decision not to slow its asset buying pace, in a complete surprise to market expectations. In his press conference Ben Bernanke pointed towards downside risks from higher mortgage rates, weaker employment figures and an upcoming fiscal stand-off to justify his decision to maintain asset purchases at $85bn a month. Treasury rates reacted dramatically and dropped from a high of 3% earlier in September to 2,63% currently, making up for some of this year’s losses, in what turns out to be one of the worst bear markets in fixed income in recent memory


Like many others in the market, we were surprised by the Fed’s announcement and argue that it reintroduces policy uncertainty and decreases the central bank’s credibility. On the other hand, a bigger focus on the broader economy and not on a single measure (like the unemployment rate) improves the Fed’s policy flexibility which in time should also provide more credibility as it will be able to support the overall economy.


In our view the Fed isn’t likely to taper in 2013. We think it isn’t likely to taper before the macro economic numbers improve notably and show that the housing market can deal with higher mortgage rates. The Fed would want to see a rise in bond yields go hand-in-hand with a rise in new mortgage applications and new homes sales. We don’t think this will happen until somewhere in Q1 2014.


Outside of the US, it seems that Europe is indeed rebounding from its recession but that is it yet too early to significantly overweight European assets, as the region’s politicians are not ready yet to make the structural changes to their struggling economies. China is benefitting from the inventory restocking globally but still faces signifcant challenges from massive leverage in its banking system, an overheated housing sector and an economy still overly reliant on export growth. Japan is now about to introduce an increase in its sales tax from 5% to 8% which leaves the door open to further monetary stimulus to compensate.


Where does that leave us in terms of strategy and asset allocation ?


We read the Fed’s surprise announcement as bullish for the markets until the end of 2013, and opened some positions in our portfolio which had suffered the most from the tapering fears: Emerging Market Equities (Brazil and Russia), Emerging Markets External Debt Bonds (Indian and Russian corporate bonds) and US High Yield bonds (BBs).


We maintain our preference for Equity investments over bonds as tapering fears will eventually return to the market and 10-year Treasury rates will re-test the 3% level before year-end. We have used the recent recovery in corporate bonds to further reduce the overall bond duration of our portfolio. It’s the credit component that we are interested in, not the rate compenent, hence our preference for holding lower rated corporate bonds with an average 3 to 4-year to maturity.


A high degree of volatility across financial markets is likely to persist throughout the end of the year. That is why a proper regional and sector selection strategy, combined with rigorous risk-management should remain the decisive factor for investment performance. As usual, don’t hesitate to contact us to discuss investment performance or financial markets more generally.