Yet another bout of volatility is testing investors’ patience. This one, however, likely marks the beginning of a return to normality, not a divergence from it. When the dust has settled, the Fed’s decision to nudge interest rate expectations upwards may be seen as a signal that they, like us, think the US economy is increasingly able to stand on its own two feet. It could be a bumpy ride, but this prospect will eventually prove better for stocks than bonds.
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Fed up? We have to deal with it – and it needn’t be bad news
We noted last month how the uncertainties facing investors seemed to be resolving into a single question, namely: is recovery all just the result of central bank support, or is there some substance behind the stock market’s rally? That question is being addressed a little sooner than we’d thought as the Federal Reserve (Fed) has pushed interest rate expectations up, but our conclusion remains the same: normalising monetary conditions will eventually prove more of a strategic headwind to bonds than stocks.
The Fed’s suggestion that quantitative easing (QE) “tapering” will likely begin in the months ahead – our economists think September is the most likely month for bond purchases to be trimmed – has triggered sell-offs in most asset classes. In fact, neither the Fed’s comments, nor the markets’ response, are a big surprise. The medium-term prospects for US economic growth have brightened as the US consumer’s resilience has been underscored by recent employment and balance sheet data, and as the tumbling budget deficit has reduced the need for a big, medium-term fiscal tightening. At the same time, market nerves are understandable because many commentators are arguing that QE and low interest rates are all that stands between us and a resumed full-blown crisis.
The Fed’s comments were focused on QE, but were always going to have an impact on interest rates. Long-term rates are affected directly: QE has helped keep bond prices high and yields low. Short-term interest rates, however, are also being affected, despite the Fed’s own guidance suggesting that they see rates staying put through 2014. The rise in long-term rates has been so pronounced that it has pulled the front end of the yield and swap curve higher with it, and forward interest rates for late 2014 have risen sharply (Figure 1), to the extent that they are more or less pricing-in a policy move.
Figure 1: US 10-year bond yield and December 2014 money rates (%)
As noted, worried economists will argue that higher rates will de-rail the US and global economy. We’re optimistic they won’t. Usually, the correlation between interest rates and growth is positive: cause-and-effect runs from the economy to interest rates, not vice versa. The current situation is admittedly complicated by the range of emergency measures that have to be unwound (“unconventional” QE alongside “conventional” low interest rates). It is also complicated by the extent of the loosening that has occurred (the Fed has bought $2 trillion of bonds already, and the Fed funds policy rate at 0-0.25% is at its lowest in our working lifetimes). But this argues for a gradual, well-signalled normalisation, not a dramatic one. The Fed, after all, is not planning to stop buying bonds overnight – and the Bank of England, the Bank of Japan and the European Central Bank have are not signalled any normalisation as yet. Admittedly, the Bank of England stopped buying UK government bonds a year or so back, but the new governor’s arrival may if anything usher in a slightly more lenient regime. In Japan, the central bank’s latest experiment with QE has only just got going. The ECB has not been trying to “print” money, but has little reason yet to signal any hawkish intent.
Lessons from earlier instances of monetary normalisation after recession and/or crisis-driven looseness are mixed. Equity and fixed income markets were volatile after a surprise Fed tightening in 1994; an episode that in several respects echoes the current one (the end of an emerging markets boom; the turnaround in the dollar), but when the dust settled, equity growth resumed, both relative to bonds and in absolute terms. Tightenings in 1999 and 2004 were more quickly shrugged off.
Policy normalisation has long been the biggest obstacle we’ve seen in the road ahead. Recurring fears of a US double dip, euro implosion and/or a crash landing for China’s economy have seemed overstated, but we’ve always thought investors would need to address the monetary question at some stage. The economic forecasts in the table below may not show robust growth, but they do show the global economy – and within it, the key US economy – continuing to avoid stall speed.
“The Fed’s prospective “tapering” of QE means that higher interest rates lie ahead. Markets have begun to price this in.”
We have been able to take some avoiding action. In mid-June we cut our recommended tactical weightings in High Yield and Emerging Market Bonds to underweight (with High Yield coming down to neutral, and an Emerging Markets underweight being extended), and raised our position in cash and short-term bonds (to neutral). The creditworthiness, and duration, of High Yield bonds is not a major concern to us at this stage, nor are the local economic prospects in the emerging world – despite visible setbacks in Brazil, China, South Africa and Turkey. But if the days of easy money in the developed bloc are numbered, so too are the cheap “carry trades” financed by such money, and we have indeed seen emerging market bonds sell off sharply in the last month.
We already had a long-standing underweight in Investment Grade Credit and, while we are tactically neutral on government bonds, they have looked so expensive to us for such a long time that our strategic (long-term) weightings are small to start with. They still look dear, even after their sell-off. If trend growth in nominal US GDP – real output growth and inflation together – is likely to settle at around 4-5%, then the 10-year US
Treasury note yield at 2.5%, albeit up from 1.4% last July, looks unsustainably low.
Gold is particularly vulnerable as we transition to monetary normality. Many investors own it for its perceived ability to guard against the more inflationary – and dollar-debasing – consequences of QE. That ability, and those risks, have been overstated, and gold – which carries no yield – is exposed as a result. Most investors’ holdings of gold should be in the low single digits as a percentage of their investment portfolio.
In the short term, stocks are, of course, vulnerable too. We’ve long preferred developed markets (on which we’ve been tactically overweight), but we’ve been no lower than neutral on emerging equities. Our Tactical Allocation Committee has been discussing possible setbacks for several months, but has so far sat tight. Stocks remain the least expensive of the big asset classes: prospective PE ratios remain materially lower than the levels suggested by profitability and the cost of funds (even allowing for higher interest rates). Emerging stocks, having underperformed since late 2010, look cheaper, but are more vulnerable to financing flows.
Stocks are volatile, and we may yet feel compelled to fine-tune our tactical stance, but for now we focus on the possibility that selling out could leave us stranded if the market rallies as we think it can. The Fed may be poised to take the punchbowl away, but we noted last month that equity investors can still have a good time sober. We see this as a good entry point for long-term investors whose weightings are sub-optimal to start with, and favour the US and continental Europe most, and the UK and developed Asia least, though even those markets seem likely to outperform local bonds.
Barclays’ key macroeconomic projections
Figure 2: Real GDP and Consumer Prices (% y-o-y)
Figure 3: Central Bank Policy Rates (%)