If You Plant Ice, You're Gonna Harvest Wind
Originally posted on October 20, 2013.
As you know, we all await the Fed word from on high this Wednesday. Will they or won't they? As always, the most important part of the equation will be the market reaction to whatever happens. Personally, regardless of nominal dollar tapering or otherwise, I expect the Fed to be quite the dovish bunch in terms of commentary. Can they light the markets up regardless of outcome? Look, when a possible Fed Chairman contender who bows out of the race even prior to being officially part of the game can light up financial assets, anything can happen.
Again, although I personally expect cooing and soothing "forward guidance" from the Fed, it's a very good bet the end game for QE has begun. Why? Just have a look at the following table.
Of course September of 2012 is when QE3 began. And this is mission accomplished in terms of an accelerating economy? Purely academically, do these numbers support tapering? In so many data points above, decelerating growth to flat at best growth is the character we see. If the Fed's true intent was to create escape velocity in the US economy, the last thing they would do right now is taper. They know QE is not meaningfully impacting economic acceleration. Don't get me wrong, it's helping to maintain growth, but acceleration anywhere even close to historical precedent has remained elusive for the entirety of the current cycle. In fact the acceleration we have seen in GDP in the last few quarters is virtually solely due to inventories. I won't go into the multiplicity of reasons why Fed tapering will occur as we could spend all day on the subject. From no wealth effect realization to meaningful financial market distortions to less Treasury issuance ahead, the Fed knows the costs and the risks (financial bubbles) of further QE are outweighing the less than hoped for positives.
Throughout the third quarter of this year, investors have become increasingly nervous regarding forward Federal Reserve monetary policy, and for good reason. From the time QE (Quantitative Easing) 1 first started in November of 2008, the Fed has been implementing QE 1, QE 2, Operation Twist and QE 3 in 53 out of 58 months over this period - 91.4% of the time. To suggest that investors in the fixed income markets had gotten used to, relied upon, levered up, and positioned exactly for Fed stimulus to continue is an understatement. Yet we need to remember that Fed monetary policy has influenced global financial markets far beyond simply US borders. Yes, we know Fed decisions will influence US financial markets, but what about the global economy and financial markets in what is an increasingly interdependent world?
In one sense, the Fed created an ice age for US interest rates by lowering the Fed Funds rate essentially to zero and by printing money to buy US Treasury and mortgage backed securities, putting further downward pressure on longer term interest rates. By design, the Fed wished to push investors into higher risk assets such as equities and real estate by lowering the return on safe bond investments. In the US, the Fed accomplished this goal as equities levitated despite lackluster economic and corporate earnings growth. Likewise, investors have turned to real estate investments in the hunt for rate of return that had vanished from the world of bonds.
But as the Fed printed ever more money to buy bonds, they created increasing amounts of liquidity that ultimately spilled over into global financial markets beyond US equities and real estate. In recent months emerging market equities and currencies have been under more than noticeable pressure. I'm referring to Brazil, India, Indonesia, Thailand, South Africa, Turkey, as well as a host of others. In addition, emerging market currencies and bond markets have likewise not been kind to investors. Although US equities have shown us double digit gains this year, an investor in an asset like the Vanguard Emerging Markets fund has lost 14% of their money on a price basis through August. In fact over the last six months, not one of the equity markets in the MSCI Emerging Markets Index beat the MSCI World Index. The last time this happened? Almost 13 years ago. Quite the juxtaposition in global equity performance, but understandable when one considers the prior period global spillover of Fed QE into the global asset markets all in the search for higher rates of return in a period that had become an ice age for nominal US interest rates.
Now that Fed "tapering" of QE is a process the markets are starting to price in and the fact that this tapering will continue at some pace until QE is ultimately terminated, glacial or otherwise, again it's not just US assets that will be affected in the rhythmic dance. As Fed liquidity expansion found its way into global equities, bonds and currencies, so now is the anticipated reduction in future liquidity causing capital to leave these very same assets (knowing full well ever increasing liquidity will not be there to support them). We've seen this before in terms of the movement of global capital, nothing new here. The Fed planting of ice in US bond markets is now resulting in a harvest of wind among global asset classes all based on the anticipated reduction in liquidity to come. Humorously, countries complaining about too much QE even six short months ago are now complaining about its eventual end. For now, we are currently seeing the anticipated liquidity reduction harvest of wind in what are academically considered the riskiest of assets - emerging market equities and bonds, currencies, and commodities - as equities of developed countries such as the US, Japan and some European nations have continued to hold up. Important message being, the Fed's QE is not limited in influence to US markets. Nothing happens in isolation. The Fed has in good part again set global capital in motion.
Back in the 1980's as Volker was practicing restrictive monetary policy, the emerging markets accounted for roughly 15% of total global GDP. A decade later that had grown to somewhere near a third and now we're looking at something closer to one-half. We also need to remember that in the central bank driven monetary expansion from 2009 to present, it has been estimated that close to $4 trillion in liquidity flowed into emerging markets in the hunt for higher returns. The capital flows into emerging nations were a tremendous gift that a number of these nations simply chose to squander, mostly in deference to political expediency. With the advent of Fed tapering and a reversal in global capital flows to the emerging nations, the countries that failed to reform are now paying the price, as are investors in these countries. Brazil, Indonesia, Turkey, India and South Africa are the poster children of the moment for having lived beyond their means (large current account deficits).
So here's the dilemma. If we think back to prior historical periods of capital outflows from emerging and developing economies, precedent was set that US interest intervened to stabilize currencies, and ultimately economies. Trust me, US interests were protecting US interests (prior period US institutional investors in these countries and their currencies). Remember Mexico? Remember the Asian currency crisis of the last 1990's? For now, the Fed has made it relatively clear that current capital flow problems in emerging nations are neither the Fed's problem nor focus. That may be fine for the Fed, but what about us as investors? Unlike the Fed, this is our problem. You've probably many times heard QE characterized as the "papering over of problems". Well, for many an emerging market this was exactly true. QE allowed a number of emerging countries to go on believing their imbalances were sustainable! It allowed them to practice discipline avoidance.
Fast forward to the present and the academic solution based on historical experience proffered for these now struggling economies is higher domestic interest rates. A tough one at present when declining currencies cause higher domestic inflationary pressures, to say nothing of having to deal with currency and financial market weakness amidst weakening internal economies. Do these economies choose to rebalance and reform against the backdrop of a slowdown in global liquidity creation? Sounds like a prescription for internal political suicide to me. The reason I'm bringing this up is that I feel it's very important that we now monitor whether the financial markets will force this reform and rebalancing in a number of emerging economies/financial markets. It just was not that long ago we saw virtually an identical replay in Greece, Italy, Portugal and Spain - and that was with historic QE expansion yet to come! The financial markets forced their own version of rebalancing on the Euro periphery countries. Will it now selectively pick off a number of emerging economies?
One watch point is the OECD composite leading indicator numbers. As of the latest data, the developed economies are showing relative strength, but the emerging market economies are showing us the weakest readings. My personal feeling is the Fed will turn a blind eye unless emerging economy issues directly hit the deck of the US economy. The emerging market current account deficit offenders of the moment - Indonesia, India, South Africa, Brazil and Turkey - only account for 6% of total US exports. The Fed is not going to blink unless say a China is negatively impacted in a loop that circles back to the US economy itself. Although the future trajectory of US interest rates and financial assets generally is certainly an important issue for investors, now is the time to keep an eye on the emerging markets. The fact is that no one knows what will happen ahead. The reversal of the greatest central bank monetary experiment on record has no roadmap.
There is one last issue concerning QE and the general comments above deserving of our attention beyond what we are seeing strictly in US markets. The Fed's QE created dollars that found their way into global financial markets. Plenty of dollars were invested abroad in search of higher returns, but so too were dollars borrowed globally. The Indian corporate sector has $100 billion in unhedged dollar denominated debt outstanding. With the anticipated reduction in QE causing currencies like the Indian rupee to fall meaningfully as of late, the dollar denominated debt of Indian companies expands due solely to increasing currency differentials. This set of circumstances, especially among emerging market nations with large dollar denominated debt, has the potential to create a spike in the US dollar. The Fed tapering QE means dollar liquidity globally will no longer be expanding at the rate it has since 2009. Less growth in dollar liquidity ahead may cause a scramble among foreign entities with dollar denominated debt to obtain dollars in the short term to pay it back. Although we are not there yet, a spike in the dollar would negatively pressure US multi-national corporate earnings longer term. But a spike in the dollar would bring ever more global capital to the US and the US dollar near term. I know this sounds crazy, but could the tapering of QE cause a real bubbling in dollar denominated assets such as US equities? Much more so than we have already seen not based on investment fundamentals, but strictly on the weight and magnitude of global capital searching out relative safety and return? We know global asset classes showing us positive returns in 2013 have narrowed considerably. Global capital has already started to concentrate. Could Fed decision making further and heighten that concentration? Again, anything can happen in a world where global capital has been set in motion.
Although the media has focused almost exclusively on the US bond market and US financial markets broadly amidst the current round of Fed decision making, we need to remember as investors that we live in a globally interconnected world - both real economies and capital markets. For well diversified and globally oriented portfolios, the influence of Fed decision making on US assets is only one component of total analysis. Nothing happens in isolation.