From Guy Haselmann of ScotiaBank
Markets have been unwelcoming and volatile since Janet Yellen’s swearing-in ceremony on Monday morning. She should not take it personally as market agita is the result of a confluence of factors. Certainly, the FOMC deserves a large portion of the blame as years of ‘pedal to the metal’ strategy demolished the ability of the Fed to know what the market’s reaction function would be once they eased off the accelerator. Few should be surprised that there were a number of risk-seeking investors who were waiting for ‘tapering’ as the catalyst to reduce risk and to remove capital from a few EM countries.
To be fair, some of the troubles that have arisen in EM countries are isolated country-specific problems, but few should dispute that capital outflows have occurred due to ‘tapering’; thus, exacerbating their challenges.
A quick reminder is in order. One main goal of the extraordinary measures of Fed policies (QE and ZIRP) was to lift asset prices. In this regard, the Fed was successful as the S&P rose 160% above its 2009 low (from 676 to 1848). The S&P is also coming off of a 32% year and posted double digit gains in 4 of the last 5 years. Credit spreads have had an equally impressive surge. Junk bond yields (oops, they are called ‘high-yield’) have declined more than 1500 basis points from 2009 spread levels.
Despite recent market weakness, the S&P is only 5.2% below all-time high prices; yet, investor worry seems quite substantial. Part of the reason is due to the speed of the descent (5%+ in three weeks). However, the magnitude (not speed) of the decline is quite small given the enormous gains in recent years; and therefore, it will not prevent the Fed from continuing its tapering path.
The drop in the 10 year yield to 2.65% should actually provide further encouragement and cover for further QE withdrawal. The hurdle to ‘taper the taper’ (i.e. pause) is exceptionally high.
There is only one way that the lofty asset price levels could have been maintained and that was for enough economic growth to be generated in order for the economic fundamentals to justify the prices. For too long, investors have given the Fed the benefit of the doubt that its policies would be able to achieve this outcome; consequently, they loaded-up on risk assets. They believed that if the economy should falter, the Fed would merely react by staying accommodative until economic activity improved. The ‘Fed put’, clearly, resulted in wide-spread moral hazard and investor complacency.
The shift to ‘tapering’ when the global economy appears under strain now leaves investors in a quandary. The fact that investors have begun to question the effectiveness of further asset purchases and whether much more can be provided without causing financial instability has roiled investor mindsets. The most recent Fed Minutes have unveiled these as valid concerns. The impact of ‘tapering’ along with the challenges exposed in China (Trust securities), Japan (Abenomics and imported energy costs), and EM countries (capital outflows and interest rate hikes) are forming a toxic mix for risk-assets.
The toxic brew, after several years of double digit portfolio gains, means that prudent investors and portfolio managers are well-advised to reduce risk (and stop justifying out-sized risk exposures by ‘fear of missing the upside’).
Risk positions have accumulated over several years, therefore three weeks of volatility (and the resulting minor correction) witnessed recently are probably only a small fraction (and indication) of what is yet to come.
Poor market liquidity will likely intensify capital flows and force transactions at sub-optimal prices. The most liquid instruments will start to command higher liquidity premiums. Should global challenges deteriorate further or contagion advance, a meaningful reduction in growth and inflationary expectations are likely to arise. This potential scenario may (be necessary to) propel Treasury prices higher and through the 2.5% yield on the 10-year note.
“Every closed eye is not sleeping and every open eye is not seeing”.
– Bill Cosby