Where does Fed’s QE3 leave us?
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There’s general acceptance that the Fed will taper its asset purchases under so-called QE3 – its third round of quantitative easing which began in September 2012 – and the consensus expect tapering to commence in March 2014. But the FOMC minutes for the 29th-30th October meeting suggest that tapering may start earlier than that and there is therefore a rising focus on the next payrolls report, out on 6th December.
But the slowing of support is less important than the actual first rate hike, and since the September FOMC meeting, the Fed has made strenuous efforts to differentiate the start of tapering from the first rate hike, with some success. When the Fed first hinted at tapering early in the summer, markets moved to anticipate the first Fed rate hike in early 2015 but now the market is pricing the first rate hike to be at the end of 2015. This is arguably good news for the Fed (and probably financial markets), although if we join the dots, it may well be that the first hike is in July 2015, with the market having been overly-cautious and now overly-relaxed.
All the macro stuff is interesting in its own right, not least because we have never faced the current policy measures and economic backcloth, but the real focus must be on the implications for asset allocation and selection and our over-riding assumption is that policy withdrawal will fundamentally alter the link between equities and fixed income, even if done gradually, and indeed, the link between equities and fixed interest has already shifted. But we do not see tapering as inherently bad news for markets.
Stepping back to think about the big picture issues, the significant policy accommodation that begain in earnest in early 2009 delivered the unusual mix of rising equity prices and stable low bond yields and with normalization of policy, so we should expect the relationship between equities and fixed interest to normalize also. The net result should be that improving economic conditions support both equity prices and higher bond yields.
Looking at recent data in the context of long term data relationships, in recent years the S&P500 has been systematically over-predicting the level of 10 year rates, by a total of more than 300bp during the Fed’s QE era. In other words, if the S&P500 were the only variable that mattered for US 10y yields (and the two were very highly correlated), then US 10y yields would be closer to 6% today rather than below 3%. This is just a statistical way of illustrating the point that exceptional policy accommodation allowed equities to rise when bond yields didn’t.
This extraordinary outcome has meant that from the start of quantitative easing to Mr Bernanke’s speech in May 2013, the Sharpe ratio (or payment for risk participation) of holding a portfolio of equity and fixed income, equally-weighted by relative volatility, has been around 2.3. This is a remarkable outcome for a long-only strategy over the span of more than four years given that the same strategy for the 20 years before the QE era was around 0.6-0.7. This difference is obviously huge and we are shifting from a period where total, long-only returns have been high, volatility has been low and investors have had little need to drift too far from their traditional equity/bond blended benchmarks. But looking ahead, the prospect of a prolonged period of policy normalization and the withdrawal of support should deliver lower overall returns, more market volatility and a need for more active management of the equity-fixed income mix – with the likely implication that investors should overweight equities and underweight fixed income.
Although it’s easy to be bullish of equities relative to fixed interest, the prospect of only gradual change to policy suggests that we should not expect a repeat of the surge in bond yields experienced over the summer, which can be seen to have been a move from ridiculously low yields to levels that better reflect the underlying cyclical dynamics of economies. What this means is that bond yields should only rise further when economic conditions improve, with a pick up in inflation and the bringing forward of expectations of policy tightening. So forwards may be right in pricing 3% US 10 year yields at end June 2014, before a shift up to perhaps 3.5% by end 2014, with it being hard to see a significant rise in US 10 year yields at a time when the Fed has convinced markets that tightening is still some way off.
A key issue is whether the Fed can anchor short-end US yields while also initiating tapering and this looks possible give that growth and inflation will likely stay modest next year – but if these variables begin to heat up, so policy will tighten, and this suggests that markets will be nervous. Against this backcloth, equities will be volatile but should win out and fixed interest ultimately loses, with yields climbing. For those with a tactical disposition, better growth and rising inflation expectations and the prospect of tighter policy may disrupt both bonds and equities, making the next three to twelve months potentially difficult.
There may be more of a message within markets, with the shift in policy most immediately being an issue for the US rather than the UK, Europe, Emerging Markets, and indeed Japan and this is compounded by US equities having done relatively well under QE3, leaving valuations relatively rich.
James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla
