Stephen Miller

FOMC announces taper

• Fed Chair “patient” on policy rate increase but will act if necessary.
• Inflation still “largely” seen as transitory but the FOMC Statement indicates less certainty on that.

As was widely anticipated the Federal Reserve’s FOMC announced that the Fed would begin winding down its monthly bond purchases at a pace of $15 billion per month, reducing Treasury purchases by $10 billion and mortgage-backed securities by $5 billion. At this stage, the FOMC expects to keep winding down purchases so that the taper process would be completed by June 2022, although it noted that changes in the outlook might occasion an adjustment to those plans.

The Fed also noted that inflation remains elevated and continued to suggest that inflation would be “largely” transitory, although the Statement indicated a little less certainty that the jump in inflation would be as short-lived as previously thought. The Statement rephrased the inflation picture portraying elevated inflation, reflecting factors that are “expected to be” transitory. The previous statement was more definite that elevated inflation was “largely reflecting transitory factors”. This was a signal of less confidence in the inflation outlook, conceding that high inflation might be prolonged. In his press conference Chair Powell admitted that the Fed took a “step back” from transitory at the September meeting. The median projection of the Fed’s preferred core PCE measure of inflation was upwardly revised again for 2021 to 3.7% (from 3.0% in June and 2.2% in March). Although it does have inflation returning to longer-run targets of close to 2% in subsequent years. In the press conference, Fed Chair Jerome Powell said that inflation pressures may wind down by the second or third quarters of next year. Recent high-frequency price indicators from both the manufacturing and non-manufacturing ISM reports indicate that price pressures remain at multi-decade highs.

The taper announcement opens up the possibility that the Fed may raise the policy rate in the second half of 2022, with nine of 18 officials forecasting a move next year in their September outlook. Chairman Powell said that tapering “does not imply any direct signal regarding our interest rate policy” and that the central bank “can be patient” when it comes to rate-hike timing but added that “if a response is called for, we will not hesitate.”

US 10 year bond yields rose on the news and stocks were up on the day. That reaction was a long way short of the “tantrum” on the scale of then Fed Chair Bernanke’s announcement back in the May 2013. The key difference this time around is that such a move had been well-telegraphed by the Fed Chairman in contrast to the “drive-by” announcement from then Fed Chair Bernanke back in May 2013.

RBA stuck on the “emergency” setting

• RBA communication insufficiently nuanced.
• RBA SoMP released Friday.

In announcing what were  – at least compared to market expectations – a marginal ‘tweak’ in what it had described as “emergency” policy settings, the RBA seemed determined to consolidate its new-found reputation as the ‘uber-dove’ of developed country central banks.

In so doing, the RBA acknowledged that it had underestimated inflation but forecast revisions are arguably modest. Perhaps more interestingly, according to John Kehoe in the AFR, the Governor appears to believe that the persistence in inflation seen everywhere else in the developed world is not as meaningful in Australia. As Sir Humphrey Appleby might say, that is a “courageous” stance. The Governor appears to point to key differences in the underlying structure of the Australian economy compared with other developed countries.  These include the labour market and the pervasiveness or otherwise of the “Great Resignation” phenomenon, fossil fuel dependency and pastutility price restraint, or even the starting point for wages growth. But such a stance is backward-looking and therefore of marginal importance. Australia is subject to the same laws of economics as other developed nations. The Governor is locked in a firm embrace of the “transitory” inflation rhetoric that other central bank chiefs trotted out in the first half of this year. Now those same central bank chiefs are disengaging from that “transitory” rhetoric because it is either not accurate or not helpful, or both.

By and large, the RBA has done a very good job in mitigating the economic dislocation wrought by the pandemic. It acted expeditiously and with considerable skill through 2020 in instituting “emergency” measures. But the “emergency” is past. The unemployment rate is below pre-pandemic levels. Inflation is emerging. Nascent financial stability concerns are growing. Wealth inequality (through rapid real estate inflation) is growing.

In this context, a bit more of a ‘tweak’ may have been considered. Just as relevant might be the nature of the RBA communication. Even an acknowledgement that the “emergency” is past.

Insufficiently nuanced communication

Part of the confusion evident in markets around the RBA meeting lies in the manner of RBA communication. In short the convulsions in the bond market are compounded by an insufficiently nuanced communication strategy that failed to emphasise the inherent uncertainties attaching to the economic outlook and attendant monetary settings.

The Governor’s Statement and press conference didn’t help.  In his prepared remarks in the press conference the Governor stated that our “forward guidance is based on the state of the economy, not the calendar” but his Statement and press conference were littered with calendar references. And, as noted above, explanations as to why inflation is different (lower) in Australia are unconvincing. In his Statement the Governor noted that “bond yields have increased recently and bond market volatility has also risen significantly.” Tuesday’s Statement and press conference did little to assuage concerns of volatility going forward.

In fairness, perhaps even in the wake of a welter of evidence to the contrary, the RBA assumes markets possess an interpretative capability way beyond that which exists.

That being the case, the RBA needs to work on communication. Perhaps focussing on quality of communication rather than quantity. In particular it might explain uncertainties in the outlook and the distribution of risks around central scenarios and their attendant implications for policy. Rather than references to calendars the Governor might have said:

• The RBA has an outcomes based forward guidance (OBFG) that is based on the state of the economy.
• These are our forecasts but uncertainties abound and the distribution around them are wide (or skewed to the upside?).
• If our forecasts are met in an accelerated fashion we policy will respond accordingly.

Tactical versus strategic

Tuesdays announcements were tactical.

However, perhaps the time has come to review that framework in a more strategic way.

In this context much is made of a move to ‘outcomes based forward guidance’ (OBFG). In essence, OBFG means that rather than be satisfied with a forecast that inflation will rise above a target (2-3 per cent in the RBA’s case), the central bank will await an outcome that they believe indicates persistent inflation above that target. Nor does the ‘outcome’ need to be inflation-based: it can be multi-pronged to encompass wage growth and / or employment objectives. The RBA has posited wage growth consistent with full employment (3 per cent wage growth with an unemployment rate around 4 per cent).

The problem is that OBFG is just as inflexible as the inflation targeting framework based on forecasts. It is also just as problematic , for example, as saying the condition for a policy rate increase “will not be met before 2024” or “at the end of 2023.”

OBFG can unnecessarily constrain the central bank.

For one thing, it might mean the central bank only acts when the inflation genie is effectively out of the bottle. The pandemic induced supply shocks are coinciding with the reversal of structural trends that account for the deflationary tendency of the past three decades: viz; globalisation of labour supply (as well as that for goods and services) and baby boomer workforce participation. Add into that mix the secular rise in female workforce participation, and the result was a massive global labour supply shock and a decline in wage growth and a structural deflationary trend. That is ending. A move to OBFG – at least the way the RBA is framing it – might be a case of ‘fighting the last war’.

For another, the various ‘outcomes’ might be incompatible. For example, unemployment may remain relatively high because of geographic or skill mismatches. Monetary policy is impotent in such a circumstance. Having monetary policy target an unemployment rate under these conditions is a recipe simply for more inflation.

This is the lesson from the 1970s. Back then, by accommodating supply shocks, monetary policy ratcheted up inflation expectations putting pressure on limited supply leading to persistent inflation and a weakening economy. Little attention was given to structural approaches including, inter alia, assessments of the benefits of public and private infrastructure investments in physical and human capital.

The upshot for the RBA is that not only do the tactics need to change but a holistic review of monetary policy strategy, including how it complements other arms of policy, may be required. One that recognises that the context in which monetary policy is framed is replete with uncertainty and that monetary policy strategy needs the requisite flexibility to adjust to a myriad of unforeseen circumstances.  

Coming up: Bank of England (BoE) meets tonight.

• US October non-farm payrolls on Friday.

The BoE meets tonight and is widely expected to lift the policy rate from 0.10 per cent to 0.25 per cent. That much is already priced by the market largely in response on ongoing upside inflation surprises in the UK and the limited prospect of any near-term dissipation of price pressures. Having said that, it is also expected there could be as many as three dissenters. Nevertheless, the differences in view are also unlikely to prevent the BoE to signal ongoing moves at subsequent meetings towards 0.50-0.75 per cent range.

For US non-farm payrolls, market expectations according to Bloomberg are for an increase in employment of around 450k (from a disappointing 194k in September) and an unemployment rate of 4.7% (from 4.8% in September). The private payroll data from ADP increased by more than expected in September at +571k versus +400k expected, although they are at best only a loose guide to the Bureau of Labor Statistics report. The data are potentially difficult to interpret as any disappointment in jobs growth may have as much to do with supply-side issues, as with any deficiency of demand. The ISM report noted that businesses reported labour supply constraints which may have accounted for at least some of the employment ‘weakness’. That notion is lent support both by the record number of vacancies (circa 10.5m) reported by the US Labor Department’s Job Openings and Labor Turnover (JOLT) Survey, anecdotal reports of stronger wage growth and greater than expected increase in average earnings in recent months, indicating that wage inflation may be taking root in the US. The average earnings number within the overall non-farm payrolls report will likely therefore be closely watched, with the market expecting an annual increase around 4.9%. Given ongoing price pressures such an average earnings number may intensify inflation concerns, particularly given the outsize increase in the prices paid in the ISM manufacturing report earlier in the week and the ISM non-manufacturing report overnight.

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Janet Yellen

Principal Global Investors Chief Global Economist, Bob Baur, comments on U.S. monetary policy, China’s latest trade data and the synchronised global upturn.

In a recent Wall Street Journal interview, President Trump said, ‘I do like a low-interest rate policy, I must be honest with you,’ quite a natural feeling from a real-estate baron who likely thrives on borrowed money. Then-Federal Reserve (Fed) Chair Ben Bernanke first took the fed funds rate to its lowest ever range of 0% to 0.25% during the financial crisis. But, current Fed Chair Janet Yellen was the ultra-dove, keeping the super-low interest rates and staying extremely reluctant to raise them.”

Is Yellen “toast” next year?

Not necessarily; President Trump did not suggest that Yellen would automatically be replaced when her term as Fed Chair expires in February 2018, saying “I like her, I respect her.” The President also noted it was “very early” in the process of rethinking Fed policy, especially with three new Fed board members to be appointed before then. Of course, these comments don’t square with then-candidate Trump’s criticisms of the Fed before last November’s election. But, a more accommodative monetary policy for longer might make the President’s growth goals easier to attain and provide a boost in later elections. Time will tell.

Global Upturn: Synchronized, Strengthening

The world began to recover from 2015’s near-recession as early as the first quarter of last year. The real recession was in manufacturing, energy, and industrial goods as oil and commodity prices plunged, inventories got too large, China had a hard landing, and the U.S. dollar surged. Markets began to reflect the opportunities for better growth late in the first quarter last year as energy, emerging market, and basic-materials stocks outperformed through the summer. After the July low in interest rates, banks, financials, and industrials led markets higher. Cyclical securities, those that benefit the most from better growth, had the best returns in 2016. The consensus didn’t catch on to the better prospects until the U.S. election forced investors to realise a global economic bounce was in motion.

Consolidation

March trade data suggest that growth in China is still picking up because imports are soaring. The late breaking first-quarter GDP report from China beat expectations in all categories, confirming the quickening. Real GDP growth picked up a tick to 6.9%; but, nominal growth surged to 11.8%, the best in years, well above the fourth quarter.

Even in Europe

With business surveys near six-year highs and unemployment trending lower, speculation is growing about when the ECB’s forward guidance of “low interest rates for longer” will be changed. So far, there has been no substantive discussion about an exit strategy. But, if the Eurozone’s better growth continues into the summer and beyond, the first indications of a policy change will likely occur by September, or before if the upcoming French election contains no big surprises.

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The impact of tapering on global markets.

Ben Bernanke on January 28 and 29 presided over his last policy-setting meeting as chairman of the Federal Reserve, before leaving the central bank two days later.

As expected, the policy-setting board decided to reduce the Fed’s monthly asset purchases by another US$10 billion from this month.

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Federal Reserve building, Washington DC.

Stan Druckenmiller, a star US hedge-fund manager, slams the Federal Reserve for “running the most inappropriate monetary policy in history”. But what seems to scare investors more is the prospect that the Fed’s quantitative easing will end soon.

Financial markets wobbled after Fed Chairman Ben Bernanke on May 22 said the Fed could wind down the unorthodox monetary tool, whereby a central bank, having already slashed its cash rate to close to zero, conjures liabilities on its balance sheet to buy financial assets. The aim of the policy is to lower long-term interest rates to encourage consumers to spend and businesses to invest.

The policy, first tried in Japan in 2001, has helped the world avoid the deflation and depression that dogged the 1930s. While the ability of quantitative easing to spur economic growth is more debatable, for it has failed to stir a lasting recovery, it’s clear the practice carries side effects, including beneficial ones for financial assets.

Druckenmiller and others say the Fed’s asset-buying misallocates resources (hard to prove) and will unbuckle inflation expectations (no sign of that happening). Other alleged spin-offs are so-called currency wars (inadvertent) and inequality because the practice favours asset owners (as the Bank of England admits). The asset-buying has certainly propelled bonds to record low yields, even Netherland bonds that were first issued in 1517, and boosted stocks to fresh peaks.

A definitive assessment of quantitative easing must wait until the practice ends. Many worry it will finish badly. They fret that the great monetary experiment of our time is yet to be halted seamlessly in any country as its economy reignites. Japan has conducted bursts of quantitative easing over the past 12 years (thus temporarily ending it), but without revitalising its economy. But there are no reasons why quantitative easing can’t end smoothly enough for the US as its economy rebounds. It may, however, prove more troublesome for other parts of the world.

The intentions

The declared Fed policy is that it will reduce its asset purchases worth US$85 billion (A$90 billion) a month in steps any time now, if economic, especially jobless, readings justify a less-promiscuous policy. The Fed expects that by mid-2014 it will have stopped the asset-buying that has swelled its balance sheet to US$3.7 trillion from US$894 billion at the start of 2008. By then, the Fed expects the jobless rate to be under 7%, from a four-year low of 7.3% in August.

The Fed can alter, even reverse, its actions at any time if the economy changes beat. Bernanke, aware that policymakers wrecked recoveries in the 1930s by braking too soon, says he won’t allow “a premature tightening”. But such comments to Congress have failed to soothe investors and speculators. Since the end of May, these “feral hogs”, as Richard Fisher, the President of the Dallas Fed described them to the Financial Times, have walloped bonds (thus boosted interest rates) and driven up the US dollar while undermining stocks, especially emerging ones, and commodities.

The financial reaction surprised Bernanke. Perhaps he failed to realise how addicted market players have become to their central-bank fix – so much so that promising reports on the US economy now trigger turbulence for they reinforce that the Fed’s asset purchases will slow soon. Another problem, though, is that some people see so-called tapering as a squeeze on credit, the scourge of the Great Depression. But tapering is not a tightening of monetary policy. If the Fed spends one dollar buying assets, it is easing monetary policy. Once the Fed stops buying assets, then monetary policy is in neutral.

The reason why the ending of quantitative easing is unlikely to be threatening to the US is that the central bank doesn’t need to sell the assets purchased under the program (outside of its normal trading of securities on the money market to control the cash rate). The central bank can hold the bonds to maturity, for, under a system of fiat money (when notes and coins are backed by nothing), the size of a central bank’s balance sheet is peripheral. The dimensions of the monetary base (notes and coins in circulation and bank reserves held at the central bank) have no influence on the Fed’s ability to control the cash rate and thus inflation. When central banks in the 1990s moved to a system of announcing cash-rate targets, they snapped the link between the money supply and the cash rate.

The political reality, though, (and Fed officials are attuned to that) is that the puffing up of the Fed’s balance sheet has sparked warnings of inflation, asset bubbles and economic imbalances. Bernanke admitted to such risks on May 22 when he told Congress the Fed’s loose policies could “undermine financial stability”. Fed officials want to shrink the balance sheet for they anticipate blame for any financial mishaps while it stays bloated. The Fed can be expected to sell assets to trim its balance sheet, and if it does, it’s tightening monetary policy. The Fed will only do this if the economy is humming enough to stoke inflation beyond its 2% limit. By selling assets, the Fed wouldn’t need to raise the cash rate as much as otherwise to keep inflation benign. This will help the recovery for it will receive fewer Fed-raises-rates jolts.

A bond surprise

Amid the tapering talk, US 10-year Treasury yields have risen about 130 basis points from 1.67% on May 1. (They peaked 2.99% on September 5.) The ending of quantitative easing may have a less-dramatic effect on US yields over the rest of the year, though. Investors have priced in the Fed’s intentions and the economic data is modest. (The US economy expanded at an annual rate of 2.5% in the second quarter). Investors are reassured that the Fed will be flexible about curtailing its asset-buying if circumstances demand and they think the central bank is determined to keep the cash rate low. Analysts only expect one 25-basis-point rise in the US cash rate in the next 12 to 18 months.

The biggest risk with ending quantitative easing is that even small increases in borrowing rates could torpedo the US recovery. The US economy’s rebound is wobbly as it is battling reduced fiscal stimulus, stricter bank-lending practices, a feeble eurozone recovery and a slowdown in China. Another risk to the Fed in shrinking its balance sheet is that it will realise losses on bond sold, if interest rates are climbing. That will force a de facto tightening of US fiscal policy. These concerns can be offset by the fact that any dip in economic growth could lead to a renewed loosening of monetary policy.

Investors can expect endless speculation about how and when the Fed will act. The jobless rate will be the best guide but the official rate fails to capture the intricacies of the labour market. The better official employment numbers shroud that many of the jobs created are low-paid and part-time and that many people have dropped out of the workforce. The gains in jobs may not empower the economy that much. The Fed could remain a bond buyer until the official jobless rate is well under 7 per cent\.

The reactions on financial markets to every economic release or Fed utterance can be considered a cost of slowing or reversing quantitative easing. The Fed should worry about bond yields for higher interest rates threaten the recovery. The Fed’s job is to control US inflation and promote US economic growth. It can ignore gyrations on currency, commodity, property and stock markets that have no obvious consequences for the US economy.

It’s hard to see how the ending of quantitative easing can ignite inflation when it will only boost interest rates, which would subdue inflationary pressures. The threat of deflation dispels notions of a bond bubble so it’s not likely that Bernanke will trigger a 1994-style bond crash. The big surprise of the ceasing of quantitative easing could well be how little disruption this causes in the US.

Trouble elsewhere

The ending of quantitative easing, however, may be more complicated elsewhere. The widespread use of the US dollar in trade and in pricing assets and the fact that many currencies are linked to the greenback ensure that US monetary-policy shifts are transmitted around the world. The problem is that while the US economy is recovering many other countries are struggling. Those with currencies tied to the US dollar are losing their export competitiveness as higher US interest rates are boosting the greenback.

The region most at risk is Europe, even with a free-floating euro. The ending of the Fed’s asset-buying may trigger a rise in global bond yields that, however gentle, hampers Europe’s economy, while exposing the limits of the European Central Bank’s bond-buying promise to save the euro. Investors may discover that the ECB can’t keep bond yields of troubled sovereigns at low-enough levels to keep governments solvent, just as a slowdown shoves more pressure on public finances.

Emerging markets are vulnerable in a different way. When quantitative easing started in 2009, US money fled to emerging markets to seek higher returns. The US-sourced capital may gush home if US yields rise. Investors fret that more emerging countries might need to raise interest rates, and thus curb growth, to attract capital to offset current-account deficits and protect their currencies from a slump that triggers inflation via higher import costs. Central banks in Brazil, India, Indonesia and Turkey lifted key rates and took other steps in recent months to prop up their currencies and balance their balances of payments. (India’s moves included capital controls).

The Fed’s actions, however, might be less of a concern than the other causes of economic slowdowns already underway in much of the emerging world. Brazil confronts falling commodity prices, sluggish growth and inflation. China is battling excessive lending. Inflation-prone India is heading to its biggest balance-of-payments crisis since 1991 because politics have stymied reform. Central European countries such as the Czech Republic, Hungary and Poland are largely untouched because their economies are better balanced. Heightened US economic activity sucking in imports may offset some of the short-term damage of the tapering, which will probably prove a hiccup for emerging countries rather than trigger a crisis. Most of the capital directed at the emerging world in recent years was for long-term investment and many countries have low foreign-debt-to-income levels and enough reserves to cope with the whims of speculators. The emerging world’s favourable demographics, abundant raw materials, rising middle class, pro-business policies, large savings pool and low labour costs will nurture its industrialisation for years to come.

Australia is better placed to cope than most countries from any Fed-induced buffetting. Australian bond yields will tick up to some extent with US yields but not fully as China’s slowdown is crimping growth and containing inflation. While rising local yields will slow the economy and steeper global interest rates will add to foreign-debt repayments, the Australian dollar will probably slide to more competitive levels and help our economy overcome the sag in the resources boom.

Over in Washington, the US-taxpayer-funded Fed should just focus on managing the US economy. It should ignore the global repercussions of its policies unless they will hurt the US. Authorities elsewhere should just better brace their economies for a less-lax US monetary policy.

Financial information comes from Bloomberg unless stated otherwise.

By Michael Collins, Investment Commentator, Fidelity Worldwide Investment

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This document is issued by FIL Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 (“Fidelity Australia”).  Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity Worldwide Investment. Prior to making an investment decision, retail investors should seek advice from their financial advisers. This document has been prepared without taking into account your objectives, financial situation or needs.  You should consider these matters before acting on the information.  You should also consider the relevant Product Disclosure Statements (“PDS”) for any Fidelity product mentioned in this document before making any decision about whether to acquire the product. The PDS can be obtained by contacting Fidelity Australia on 1800 119 270 or by downloading from our website at www.fidelity.com.au. This document may include general commentary on market activity, sector trends or other broad-based economic or political conditions that should not be taken as investment advice. Information stated herein about specific securities is subject to change. Any reference to specific securities should not be taken as a recommendation to buy, sell or hold these securities. While the information contained in this document has been prepared with reasonable care, no responsibility or liability is accepted for any errors or omissions or misstatements however caused. This document is intended as general information only. The document may not be reproduced or transmitted without prior written permission of Fidelity Australia. The issuer of Fidelity’s managed investment schemes is FIL Responsible Entity (Australia) Limited ABN 33 148 059 009. Reference to ($) are in Australian dollars unless stated otherwise.  © 2013 FIL Responsible Entity (Australia) Limited.  Fidelity, Fidelity Worldwide Investment and the Fidelity Worldwide Investment logo and F symbol are trademarks of FIL Limited.

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Investors need to be flexible given the US situation.

Ever since the U.S. Federal Reserve (Fed) Chairman Ben Bernanke’s “tapering” speech on 19 June at a press conference in Washington, D.C., which fueled investor anxiety regarding the future course of Fed monetary policy, many investors are asking one thing, is this the start of something more ominous?

We don’t think so. Global economies are structurally too weak and inflation pressures, for the most part, nonexistent for a potential rise in interest rates to signal the start of a secular bear market in bonds and other financial assets. This does not mean volatility won’t continue to be high, nor does it mean rates won’t notch higher before settling down. It does suggest global markets now expect a full Fed reversal rather than just tapering, such that there is a lot of bad news already built into the markets. As U.S. mortgage rates have risen back above 4%, there is an added drag on the economy that could affect current growth dynamics and keep inflation further retrenched.

So what does this mean for investors?

In such an uncertain environment, investors need to keep the following in mind.

First, they need to be flexible, retaining both the resilience to stay on the road when hitting S-curves and the agility to turn left or right when coming into T-junctions. This means having real diversification, being able to play both offence and defence, maintaining liquidity and dry powder, considering tail risk hedges and employing strong and proactive governance structures to be able to move quickly and forcefully when necessary.

Second, investors may want think about pivoting to “alpha” (with a focus on generating excess returns) as the days of easy “beta” (simply earning high market-based returns) are behind us. This includes building smarter betas, adopting better benchmarks and adding discretion in core portfolios. And, for those with specific absolute return, income or hedging needs, it means moving to more outcome-oriented solutions.

Third, we believe investors should stay active. This is more than a good health tip. It means maximising investment flexibility by not locking in passive allocations, beta exposures, portfolio structures and hedges. There are times when passive strategies can offer value, but likely not in the current environment.

Fourth, they need to be forward-thinking. Move away from asset-class-based to risk-factor-based asset allocations; from historical to forward-looking return methodology; from market value to GDP-weighted benchmarks; and from alpha-generating strategies that worked in the past to those better suited for today’s investment landscape. History provides important perspective, which we ignore at our own peril, but we have to look forward to stay on the road.

Finally, investors need to be patient. We’re still in a state of disequilibrium. Now is not the time to go all in or be all out.

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Investors who remain on the lookout will benefit from changing conditions.

We’re more than half way through 2013 and after some early signs of a return to equity, it’s fairly clear that investors need to remain switched on and active with their investment allocation decisions to achieve the best possible outcome. A few months ago, amid strong gains for US and Japanese equities and a more patchy performance from emerging markets, some analysts noted a distinct reduction in correlation, which had seen markets move in lockstep with every twist and turn of risk sentiment. They saw signs that markets were returning to fundamentals, where the individual stock merits and country-level macro factors were finally beginning to re-assert themselves in place of synchronized market swings linked to global risk factors, such as Eurozone sovereign debt issues and the US fiscal cliff.

Then along came Ben Bernanke’s comments about the Fed tapering its QE policy. That sent markets into another tailspin in May, prompting an emerging markets sell-off and also a sharp rise in US Treasury yields. Fidelity Worldwide Investment’s Global CIO for Fixed Income noted that for the week ending June 26, around US$5.7 billion was pulled out of emerging market debt funds – the biggest single weekly move in the history of emerging market debt flows. Some of that has flowed back subsequently, amid signs that the US recovery and inflation outlook remain relatively subdued. But the size of the numbers involved only goes to show how many investors were forced to make a relatively sudden switch in allocations to protect their investments. Looking at Asia equities, Thailand and the Philippines saw around 20% lopped off frothy valuations after a strong run, in a broad risk-off move by investors.

And it’s not just a question of keeping on top of tactical turning points. There are clear signs that some fundamental long-term trends are reversing. A few years ago it was a useful analytical framework to talk about a “2-speed world” – roughly divided between faster-growing emerging markets and slower-growing developed markets. However, it’s becoming increasingly clear that this simple contrast is no longer sufficient. There is no “free lunch” in emerging markets anymore and investors must do their homework on which countries are offering attractive growth opportunities based on innovation, superior products and true economic reform and those countries which have simply been riding the wave of a weak dollar and related commodities boom without reforming their markets. As Reuters News recently reported, investors who have plowed some $400 billion into raw materials markets over the past 10 years are accelerating efforts to change their strategies, if not their allocations, on the growing belief that the commodities “super-cycle” has come to an end^[1].

Likewise there are clear signs that a three-decade long bull run for bonds has turned a corner, as central banks (particularly in developed markets) get set for a resumption of growth and inflation. The exact timing of interest rate rises is hotly-debated but there can be little doubt that US bonds are unlikely to test new lows anytime soon. And this takes us neatly back to the improved outlook for the US economy and by association, the US dollar. If we go back to Christmas 2012, most people who depend on financial markets for a living probably had their financial news and smartphones close to hand over a turkey lunch as the US prepared to go over the fiscal cliff amid disagreement over the US budget. However, since then there has been a marked improvement in the US fiscal and trade deficits, helped by spending cuts and rising corporate tax receipts. The US economy is continuing to grow at a reasonably healthy rate, bolstered by a steady housing recovery. There is also a growing realization that the recent breakthroughs in US shale gas extraction have the potential to revolutionize US energy supplies.

So what does this all mean for investors? It means investors need to remain active and alert and be prepared to reassess their portfolio allocation decisions regularly. Keep on top of the markets but also do your homework on long-term economic shifts.  It means that a simple, passive allocation strategy or a “choose once and leave” approach are particularly at risk of poor end results. June was a particularly bad month for many ETFs. More than anything, it means that investors need to look at fundamentals and/or invest with professionals who are dedicated to uncovering real value, growth opportunities and companies with genuine levels of competitive advantage. Thankfully some recent reversals for stock markets have not been accompanied by elevated levels of volatility – in 2008 equity volatility spiked into the 30-40% range and although it moved above 20% briefly in recent months, it has since dropped away. This means that a fundamental, bottom-up approach to investment, assessing each opportunity on its merits rather than as part of a synchronized dance driven by external factors, is once again the best approach for investors.

Article by Gareth Nicholson, Investment Commentator at Fidelity

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US automobile industry

The creeping slowdown in both the US and China has broad ramifications for Australia and global equity markets, a leading fund manager warns.

Australian Ethical international equities portfolio manager Nathan Lim says ‘we have kept our economic assessment for China at neutral as it still seems economic growth is only decelerating. Regardless, this does not bode well for Australia’.

‘Similarly in the US, Fed chair Ben Bernanke reminded the market that the Fed’s unconventional monetary policy must have a finite life and stimulus would need to be withdrawn as the economy continues to improve. This has resulted in tempered investor sentiment,’ says Lim.

More specifically, Lim says the US automobile industry is being coerced into selling electric cars at substantial losses to comply with government policy.

‘Whilst we fully support policy that seeks to correct market distortions – such as pricing the societal cost of pollution, we believe this is very poor policy as it creates an artificial economic disincentive to address the unpriced externality of air pollution from vehicles.

‘This is inherently wrong because governments have been consistently very poor at picking technology winners and at its heart is targeting increased electric vehicle sales not air pollution per se.

‘In our view emissions reduction targets and economic incentives are a far better driver of change.’

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Fed’s QE exit

We have known for some time that Ben Bernanke has worried about the build-up of risks stemming from investors’ reach for yield which has ultimately stemmed from the Fed’s highly accommodative monetary policy. On the other hand, we also know that Bernanke is fully cognisant of the risks associated with any sudden pick-up in yields from current depressed levels. Indeed, if bond yields were to rise too quickly upon commencement of the exit process, we would expect the Fed to manage the market’s expectations, possibly by pausing, or even temporarily reversing, the normalisation process.

Interestingly, in his March 1st speech, Bernanke pointed out that if policy rate hikes were implemented too soon this could even cause bond yields to fall. Although he did not explain how, it is our view that one way this could happen would be if an initial rise in yields caused a jump in interest costs, leading to a reduction in disposable income and slower demand for housing.

The 1994 comparison

Of the four rate-rising cycles since 1988, only the 1994 cycle resulted in the US 10-yr yield ending the cycle more than 75bps higher than when the cycle started. Thus only in 1994 did we have a relatively disorderly impact from Fed policy normalisation, with the rate rising cycle resulting in a capital loss on bonds. However, with coupons at 2% or lower, yields rises of 25 basis points or more per year will generate a capital loss.

To be clear, whenever policy rates are normalised, bond yields will go higher. However, that does not mean we will necessarily experience the disorder of 1994. It is difficult to say what the ‘new normal’ for the Fed Funds Rate will be. Assuming equilibrium inflation expectations of 2.5% and an equilibrium real short rate of 1.5%, perhaps 4% is reasonable. The Fed considers the bond yield as decomposed into an expected inflation rate plus an average real short rate plus a term premium. For example, a 2.5% expected inflation rate + a 1.5% real rate and a + 1% term premium, gives a 5% yield. But, it is the speed of the rise that is of critical importance both to investors and the economy. The good news here is that market currently believes it will take more than 10 years to normalise the Fed Funds Rate, implying a slow and manageable rise in yields.

The biggest area of concern for investors will be upward pressure on yields arising from higher inflation expectations as opposed to economic improvement and normalisation. For example, such a situation could arise if the FOMC persisted with a loose monetary stance for too long even as inflation was picking up. While we do not completely dismiss this risk, we feel this is unlikely because the Fed has stated very clearly that it will only unwind monetary accommodation once unemployment drops sufficiently and/or inflation rises beyond its threshold levels. The reference to inflation is key here because it is specifically intended to comfort the market that the Fed won’t allow inflation to become uncontrollable.

Another risk factor worth considering is an increase in the term premium. The most likely cause of this would be a deterioration of the US fiscal situation leading to increasing investor aversion to Treasuries. However, while this is also something that should not be dismissed entirely, we still see few parallels with the 1994 situation, when policy adjustment by the Fed led to a sharp spike in yields in a relatively short time frame. The big difference between now and 1994 is the Fed’s much improved communication with the market. In 1994, yields rose quickly because the market was effectively caught out and surprised by FOMC’s intentions – the FOMC had only recently began to issue policy statements at this time. Today however, we know that the Fed places an immense amount importance on its guidance to the market. Given this, a large rise in yields is only likely if the Fed unexpectedly shifts its stance on how it intends to normalise policy. While such a “blind-siding” in terms of market perception and Fed actions is possible, we think it is unlikely.

The sequence of the exit process is more difficult to predict, because the Fed will want to remain flexible enough to take decisions while the exit process progresses. However, an end to QE will almost certainly be the first step, followed by the winding down of treasury and agency MBS debt that was being rolled over – although this process will take place over the course of many years. As a next step, it’s possible that the Fed raises the interest rate on banks’ excess reserves (IOER) while scaling back the quantity of its reserves via repos (reverse repurchase arrangements) and offering depositary institutions term deposits. Asset sales would be a last resort to reduce the size of the balance sheet – used only in the event that the Fed wants to drain reserves faster than it currently anticipates.

Trevor Greetham, Asset Allocation and Investment Solutions Director, also commented: “Over the longer term, it is natural for bond yields to rise during an economic recovery and this isn’t usually a problem for stocks as long as the rise in yields is orderly. That said, the debate around QE exit is premature. US data has been weak and lead indicators are rolling over. Meanwhile, US headline CPI is 1% and falling. This data is more consistent with easing than tightening.”

By David Buckle, Head of Quantitative Research, Fidelity Worldwide Investment

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This document is issued by FIL Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 (“Fidelity Australia”).  Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity Worldwide Investment.

Prior to making an investment decision, retail investors should seek advice from their financial advisers. This document has been prepared without taking into account your objectives, financial situation or needs.  You should consider these matters before acting on the information.  You should also consider the relevant Product Disclosure Statements (“PDS”) for any Fidelity product mentioned in this document before making any decision about whether to acquire the product. The PDS can be obtained by contacting Fidelity Australia on 1800 119 270 or by downloading from our website at www.fidelity.com.au. This document may include general commentary on market activity, sector trends or other broad-based economic or political conditions that should not be taken as investment advice. Information stated herein about specific securities is subject to change. Any reference to specific securities should not be taken as a recommendation to buy, sell or hold these securities. While the information contained in this document has been prepared with reasonable care, no responsibility or liability is accepted for any errors or omissions or misstatements however caused. This document is intended as general information only. The document may not be reproduced or transmitted without prior written permission of Fidelity Australia. The issuer of Fidelity’s managed investment schemes is FIL Responsible Entity (Australia) Limited ABN 33 148 059 009. Reference to ($) are in Australian dollars unless stated otherwise. 

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