US equity indices have posted above-average gains of 4%-5% in the second quarter, making for a very strong first-half performance in 2013. Investor portfolio preferences have continued to shift toward equities despite a persistently slow rate of economic growth, both at home and abroad. A back-up in long bond yields, associated with investor concern about the onset of "tapering" of the US Federal Reserve’s (Fed) current quantitative easing (QE) programme, may also be leading investors to rethink their fixed income exposures, as small increases in yield can induce large capital losses when starting from a position of historically low yields. Cash yields are still exceptionally low in nominal terms, and negative in real terms, which makes sitting on the sidelines somewhat expensive. Commodities have continued to weaken in the face of a euro-zone recession, subpar emerging markets growth and a backdrop of continued disinflation in most developed markets (despite the expansion of central bank balance sheets). By default, investors are finding few attractive prospects outside of equity markets.
Regarding the main question of the Fed "tapering" its current QE programme, Chairman Bernanke indicated in the late May Federal Open Market Committee meeting that the prospect of smaller monthly purchases of bonds by the Fed would be raised "in the next few meetings". The question of how investors may reassess their portfolio exposures once QE measures are reduced, and eventually removed, has been lurking in the background for some time. Any Fed exit strategy is likely to prove especially challenging for long government bond investors.
Bond investors are likely to face an adverse risk/ reward profile until interest rates have renormalized, or even overshot to the upside. It is a mathematical property of bonds that large falls in bond prices will accompany small change increases in bond yields when bondholders start from a position of low nominal bond yields. Given a low starting yield, not much of the ensuing bond price decline can be covered by the coupon of the bond. Of course, investors that do not have to mark their bond portfolios to market, and can reasonably expect to hold onto their bonds until maturity, need not be so concerned about a renormalization of rates. But this comprises a rather small segment of the bond investing universe. Even then, buy and hold bond investors will face an opportunity cost of holding lower yielding issues. In the extreme, should the shorter end of the yield curve rise quickly, banks could find themselves holding a legacy portfolio of low yielding loans and other securities. Net interest margins of banks could be squeezed accordingly, with possible adverse effects on credit provision to households and firms, as well as fire sales of bank holdings.
For the moment, the mere question of the onset of tapering has lifted the volatility of asset prices in a number of asset classes - especially emerging market equities, which are viewed as an indirect beneficiary of quantitative easing by developed market central banks. Higher asset price volatility, in turn, tends to lead conventional risk budgeting approaches to recommend a reduction in risk in portfolios. This process can easily feed upon itself, until yields on investments back-up sufficiently to attract new investors back into riskier assets. However, while US equity prices are off their highs in May, the decline has been short-lived and shallow, and we believe this measured response in US equities is appropriate.
The US is one of the few developed markets where a central bank has successfully employed QE to raise bond, equity and real estate prices. The US is also one of the few developed economies with a positive real gross domestic product (GDP) growth rate and a falling unemployment rate. The Fed has struggled since the global financial crisis to get favourable results in the real economy. Unconventional monetary policy has achieved the goal of lifting asset prices and making it easier to deleverage and to refinance private debt at lower interest rates. But it is equally clear that private sector spending and real economic growth have responded in a very tepid fashion to these measures, for a variety of reasons, not least of which has been the need for the private sector to deleverage.
Consequently, it does not make much sense for the Fed to take steps that end up undermining its own longstanding effort to help right the ship, especially with fiscal headwinds, according to the Fed’s own staff, reducing real GDP growth by 1%.
In addition, despite the concerns of some economists and investors, the expansion of central bank balance sheets has not been matched with a marked acceleration in consumer price inflation. This is thoroughly consistent with the dampened transmission mechanism from higher asset prices to higher private demand growth that has prevailed since the global financial crisis. Headline and core inflation measures have been fading, and are well below the 2% threshold that Fed considers an indication that it is achieving its price stability objective. The headline consumer prices index (CPI) measure is down to 1.4% as of May (see Figure 1) and the core personal consumption expenditures measure (that is, excluding food and energy prices) favoured by the Fed, has also dropped to a 1.1% yearon- year rate of inflation.
In the absence of robust private demand growth or escalating inflation pressures, we are hard pressed to expect anything but cautious retrenchment by the Fed in the months and quarters ahead. As it stands, second quarter real GDP growth is tracking below 2% on a quarterly annualized basis - less than half the pace of first quarter growth, and the headline CPI is slipping into territory that last led to outright price deflation. Manufacturing production has slid 2% yearon- year as of May, and the purchasing manager’s index has dropped below 50 again, into contractionary territory. Export growth and durable goods orders have yet to show any significant improvement in momentum.
All of this suggests the Fed will exit QE in the months ahead. While US equity market returns may not be as strong in the second half of 2013 as they have been in the first half, we see few other asset classes offering more attractive opportunities for gains in this rather muted global growth environment.
Figure 1: Consumer price index for all urban consumers: all items
Source: US Department of Labor: Bureau of Labor Statistics, 5 January 2013