What US Fed tapering means for your portfolio
After months of speculation, the US central bank, the Federal Reserve, will finally start ‘tapering’ or withdrawing its quantitative easing (QE) programme.
The Fed will reduce its asset purchase programme by $10bn per month from January 2014, taking it from $85bn to $75bn.
The Fed first introduced QE in late 2008 to boost lending and spending to stimulate the US economy during the financial crisis.
This massive stimulus has been a key factor in supercharging stock market returns during 2013. With yields artificially squeezed on traditionally lower risk investments, i.e. bonds, investors have been forced further up the risk curve to achieve real returns ahead of inflation.
That has helped propel the US market almost 30% higher during 2013, with the S&P 500 now at a record high, but with stellar returns also seen on other developed market indices such as the FTSE All Share (17%) and FTSE World Europe ex UK (22%).
The move to gradually scale back the stimulus measures indicates the central bank’s confidence in the improving US economy.
Here, Jason Hollands of wealth manager, Bestinvest, explains some of the potential investment implications of tapering:
1. A year of transition for bond markets.
Since tapering first hit the headlines, bond markets have already begun to adjust to expectations of a reining in of the artificial support they have had from QE and the growing risks that presents to prices, with spreads widening on 10-year Treasury bonds by 100 basis points in nine months.
Depending on the scale of tapering bond prices are likely to further soften and yields rise, with knock on effects across developed market government bonds and investment grade corporate bonds.
At some point however bond markets will start to become more attractive again as markets “normalise”. 2014 is therefore going to be a year of transition for bonds.
2. More pain for emerging markets?
2013 has been a volatile year for emerging markets with currencies under pressure, bond yields rising and significant stock market underperformance compared to the developed world. That’s because of a combination of growing concerns over the sustainability of the Chinese economic model but also the spectre of tapering.
The emerging markets have benefited from US money printing and ultra-low yields, as international investors have been prepared to take more risk and low borrowing costs stemming from QE have help fuel an explosion of debt issuance in the emerging world, particularly Asia. Total emerging market debt is estimated to have doubled since the US Federal Reserve embarked on its QE foray.
However, as the old saying goes, “when the tide goes out, you can see who has been swimming naked” and rising US bond yields could well trigger a re-pricing of risk across the globe, exposing structural weaknesses in the emerging markets that have hitherto been overlooked.
3. Good news for Japanese exporters
A tapering /wind-down of QE in the US will potentially take place at a time when the Bank of Japan is engaged in a massive stimulus programme that relative to its GDP is a of a significantly greater scale that US QE.
In fact is makes US QE look like a vicar’s tea party in comparison to an all-night rave.
If the US tightens its monetary policy, the dollar should strengthen at the very time when continued money printing in Japan may well see the yen weaken further. A much more attractive exchange rate would boost the competitiveness of Japan’s exporters – think cars, consumer goods – as well as make Japanese assets continue to seem attractively priced for international investors. We think this has the potential to propel Japanese equities higher, despite spectacular returns during 2013.
4. Invest where the sugar rush is set to continue
It is difficult to know how the US stock market will ultimately react to the onset of tapering, as opposed to mere speculation about when it will start. However the starting point is that on Cyclically Adjusted Price/Earning basis, US stocks look expensive. Indeed, legendary value investor Warren Buffett recently confessed that he couldn’t find anything to invest in.
What we do know is that markets like artificial sugar-rushes and we therefore think that in 2014 investors should focus on those markets where extraordinary measures are likely to continue or commence: Japan is one, but the other is the eurozone.
That doesn’t mean we are bulls on the eurozone economy. Quite the opposite: Europe is struggling and it has been behind the curve in taking the types of action seen elsewhere. Economically it is staring down the barrel at a scenario of falling prices. However, we think this is simply going to strengthen the likelihood of the European Central Bank having to pump money into the market and the moves could get increasingly bold/desperate. As we know from elsewhere, massive stimulus measures translates into risk asset inflation.
5. Will Gold remain under pressure?
The classic case for gold is that it is a store of value when paper money is being debased in value, yet during 2013 the yellow metal met its Waterloo. A wind-down in money printing by the US doesn’t support the case for gold and historically there has been a strong inverse correlation between dollar strengthening and the gold price. Furthermore, when yields on assets such as bonds start rising, as they have done, the opportunity cost of holding a zero-yielding commodity like a precious metal becomes higher.
Bestinvest fund recommendations for 2014:
– Japan equities: GLG JapanCore Alpha Equity I H GBP; this is the sterling hedged version of GLG’s flagship valued-biased large cap Japanese fund managed by veteran manager Stephen Harker. The portfolio includes leading exporters Sony, Nintendo and Toyota. We also think a good companion would be the tiny (£79m) CF Morant Wright Nippon Yield fund which has a strong small cap bias. Morant Wright may not be a household name but it is a specialist Japan boutique with a management team comprised of former leading lights at a number of City institutions.
– European equities: Threadneedle European Select is our top choice as a core European equity fund with a focus on large global businesses. This could be dovetailed with the small/mid-cap biased Baring European Select fund.
– Emerging markets: it is difficult to catch a falling knife and we remain cautious for now but on the back of a further shake-out, long term investors might consider Lazard Emerging Markets or Templeton Emerging Market Investment Trust (currently trading at a 10% discount).
– Bonds: for now we think investors should focus on funds with flexible mandates to shift across the credit and duration spectrum. Try the PFS TwentyFour Dynamic Bond fund who manage team have a background in fixed income trading at leading investment banks and a good feel for market dynamic.