Fed Tapering Ahead, And Unintended Consequences

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By Rudi Filapek-Vandyck, Editor FNArena

Around this time of the year, investment bankers and strategists update their calculations and assumptions in order to provide their clientele, and investors in general, guidance about what the new calendar year might bring.

Investment strategy updates and suggested asset allocations are being issued and distributed on a daily basis. This will likely continue for the next two weeks or so.

Already one observation stands out: some strategists in the US are advising investors should go All-In. In US equities that is.

Their strong conviction in yet another good year for US equities is built on continued gains in profits for US corporates, on stronger growth for the US and for developed economies in general, on gradual and slow tapering by the Federal Reserve and on the fact that government bonds are now in a long term bear market, likely to generate negative returns in 2014.

The realisation of the latter is believed to break down the final barrier of resistance next year. Many believe 2014 will be the year of the Big Switch, when money flows out of government bonds and into equities. What (most) investors do not necessarily appreciate is that bond markets are multiple times the size of equity markets, so relatively small changes in allocation can trigger a large impact on lower volume assets, and equity markets remain in a low volume environment until this very day.

This scenario doesn't even mention the "cash on the sidelines" as a potential co-contributor.

History shows all of this can potentially lead to a "melt-up" in equities; when incoming funds chase ever rising share prices, causing a race to the top.

Ironically, strategists in Emerging Markets are advising their clientele to seek out safe havens in local equities as the end of Fed liquidity stimulus is thought to herald the departure of funds flowing back to the US. Asian bonds and other high yielding instruments are seen as one logical victim of the reversal in global liquidity.

Already, Asian and other Emerging equity Markets have performed poorly this year in anticipation of the US Fed reducing its monthly bonds buying program.

Wait a second, I hear some of you asking, haven't US equities also received support from Fed liquidity? What about all those charts that circulate across the Internet about how equities have rallied alongside QE1, QE2 and QE3? Surely, there must be some drawback from any reduction?

Well, there probably will be. Byron Wien(*), Vice Chairman at Blackstone and widely accepted as one of the wiser voices in the market, recently put some context around the familiar numbers. The Federal Reserve has been buying US government bonds (and some other yield securities) at a rate of US$85bn per month.

Wien believes about three-quarters of these funds have subsequently flowed into financial instruments (making the Fed's liquidity operation a highly inefficient policy of stimulating the actual economy). About three-quarters of all funds flowing into investments went into US equities, he estimates. This brings us to an additional monthly inflow of circa US$47bn.

That sounds like a lot, but the daily volume in dollar turnover for the New York Stock Exchange and the Nasdaq, reports Wien, is about US$34bn. This makes the extra stimulus provided by the Fed look a lot less significant. Nevertheless, neither Wien nor other experts are disputing the fact that QE has had a positive influence on US equities, but these estimates suggest the major impact has come through indirect channels, such as increased confidence, lower bond yields and a weaker USD.

Wien has remained sceptical about "peak" corporate profits in the US throughout the new bull market over there, but so far, he can only acknowledge the surprise has been to the upside and indications are 2014 might yet again surprise to the upside.

So how is all this going to impact on financial assets in Australia?

Firstly, if US Treasuries are trending lower (yield up), as everyone expects will happen next year as a result of the Fed withdrawing as a strong buyer of the asset, then history shows Aussie bonds are likely to follow suit, regardless whether the RBA drops its easing bias or not. This may not necessarily translate into negative returns at face value for owners of Australian bonds, as the local yield is higher than in the US, but it will make local bonds less attractive and it may translate into a negative real return (adjusted for inflation).

Secondly, a combination of Fed tapering and stronger US economic growth should lead to a stronger US dollar. This should make it easier for the RBA to achieve a cheaper AUD, in particular if the non-mining segment of the Australian economy remains lacklustre for longer and if China keeps liquidity tight, leading to further restraint on Chinese growth numbers next year.

If, as many anticipate, additional volumes in iron ore will finally pull down the price from near US$140/tonne towards US$120/tonne (or even lower) from the third quarter next year onwards, AUD may well drop below US90c in 2014. (No guarantee included though).

Thirdly, real estate in the major population centres in Australia is enjoying a firm come-back as investment destination for risk averse Baby Boomers, upcoming wealthy Chinese citizens and investors of other ilk. Add record numbers in local immigration and it seems unlikely this trend is going to reverse anytime soon. Moreover, it remains yet to be seen whether higher bond yields and a weaker AUD will have any effect, which is probably one key reason why risk averse investors continue to like real estate as an asset for investment.

Most investors in Australia will be worried about any adverse effects for the local share market and here the positives are already being reflected through stellar performances this year for the likes of Amcor ((AMC)), Brambles ((BXB)), Aristocrat ((ALL)), CSL ((CSL)), Ansell ((ANN)), Computershare ((CPU)) and, yes, even QBE Insurance((QBE)), though mostly pre-profit warning.

In anticipation of Fed tapering on the back of a stronger US economy, investors have sought exposure through locally listed companies with significant operations in the US, or significant FX benefits, or leverage to US debt/bond markets.

Australian banks and resources stocks, two of the main pillars underneath the Australian share market, do not qualify as natural beneficiaries. To foreign investors, Australian banks are simply too well-priced, in particular given the prospect of a weakening AUD, rising bond yields, and with the availability of much cheaper bank stocks with much stronger growth outlooks elsewhere.

Resources stocks usually stand to benefit from a pick-up in global growth, but this time around little seems "as per usual". Global growth prospects are mostly carried by developed economies next year, the world's least commodities-intensive regions. There's plenty of supply in most markets, which is likely to keep a lid on prices. The key contra-argument here is that many prices (nickel, aluminium, uranium…) are already so depressed, a small improvement in investor sentiment can potentially cause a relatively important price adjustment higher.

Another natural headwind is represented by prospects of a stronger USD. Yet another one comes from new metal warehousing rules that should improve physical availability and push physical premiums lower. I have a suspicion that large Wall Street firms abandoning trading commodities directly due to authorities tightening the rules is already having a negative impact this year.

However, the BIG question mark remains how Fed tapering, and thus reduced global liquidity, might or might not impact on commodity prices. The anticipated capital flight from Emerging Markets can potentially disturb any connection with actual demand, even if only temporary. It can also impact on demand itself.

Analysts at CBA are very cognisant of the risks, but they draw confidence from the rather muted drop in prices earlier this year when the prospect of Fed tapering was first unleashed on the global investment community.

The Biggest Loser among all, however, is likely to be gold. A strengthening US economy, a strengthening US dollar, rising US bond yields, a general pick-up in investor risk appetite and the Federal Reserve winding back its excessive liquidity stimulus program shall all become major headwinds for yesteryear's safe haven asset.

Investors who bought gold as an inflation hedge should also take into account that, firstly, global inflation remains exceptionally low and it remains deflation instead which spooks central bankers in major developed economies, and, secondly, gold previously peaked in 1980 and subsequently went through a relentless bear market that lasted for two decades. It took the price down from US$860 to US$250/oz.

It's not that there was no inflation throughout that period, but Fed Chairman Paul Volcker at that time put an end to the era of hyper-inflation, and that is a completely different animal than your ordinary consumer price inflation. Paul Sheard, Chief Global Economist and Head of Global Economics and Research at Standard and Poor's, recently published an excellent explanation as to why the end of QE will not cause hyper-inflation. His report can be downloaded via the following link: http://t.co/LCXIeEitLN

My view has been, and still is, that if global equities continue their bull run, as happened post 1980, gold is in real trouble. Expectations that gold miners accumulating losses will provide price support is a rather weak argument. One only has to look at comparable events for aluminium or nickel to see that those processes are slow-going and in the case of gold certainly more complex.

Further undermining this argument is that gold miners can, and mostly are in such process right now, lower their production costs and this in itself means the price can fall even further.

As expressed multiple times in the past, it is my view that gold should not be treated as a speculative instrument but instead as an insurance policy. The weight attributed to gold in any investment portfolio should thus be directly linked to the investor's overall anxiety about the world and the global financial system in particular.

Note the price of gold has fallen in excess of 26% so far in 2013.

Lastly, there is always room for unintended consequences. Reducing and then unwinding the US' largest financial experiment in history is unlikely to occur as swiftly and as smoothly as the architects behind the policy would like everyone to believe. More volatility in financial markets is within this context probably the easiest prediction to make for next year.

As far as share market strategies and potential investment returns are concerned, 2014 might well shape up as a very interesting year indeed. As strategists at BA-Merrill Lynch pointed out recently, the faster economic growth turns out to be, the greater the risk of negative returns to financial assets, while on the other hand, the slower the growth, the greater the risk of localized investment bubbles.

BA-ML strategists also believe equities will finally have that correction that has been long overdue, in the first half of 2014. Their prediction: "There will be blood".

Looks like 2014 is going to be a lot more interesting than 2013. Bring it on!

This is my Final Weekly Insights for 2013. I wish you all a wonderful end-of-year break. Weekly Insights shall return in late January.

(This story was written on Monday, 09 December 2013. It was published on the day in the form of an email to paying subscribers.)

^(*) Byron Wien may be considered a wise and intelligent voice, his predictions for 2013 proved all wrong except that Japanese equities have experienced a substantial rise on the back of substantial JPY weakness (source: Business Insider Australia). Just goes to show… how difficult it is to remain accurate when making predictions while so many factors are moving and in play.

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website)

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THE AUD AND THE AUSTRALIAN SHARE MARKET

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MAKE RISK YOUR FRIEND – ALL-WEATHER PERFORMERS

Things might look a lot different today than they have between 2008-2012, but that doesn't mean there are no lessons and conclusions to be drawn for the years ahead. "Making Risk Your Friend. Finding All-Weather Performers", was published in January this year and identifies three categories of stocks that should be part of every long term portfolio; sustainable yield, All-Weather Performers and Sweetspot Stocks.

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