Cut off by their sugar daddy
Investors fear the loss of central-bank support
Jun 29th 2013
THE pattern is wearily familiar. In every year since 2010 global markets have started the year in optimistic mood only to run into trouble in the late spring and early summer. This time there is little doubt about the cause. The Federal Reserve has suggested that, unless the American economy deteriorates, it may start to slow the pace of its asset purchases—currently running at $85 billion a month—later this year. The purchases may stop altogether sometime in 2014.
Ever since the Fed began its latest round of quantitative easing (QE) last year, investors have felt they had a one-way bet. As David Simmonds of Royal Bank of Scotland remarked: “In this period the imperative was to venture forth with liquidity and to find some risk-seeking home for it, some extra yield, some enhanced return. This was a great rotation out of any remaining cash and into anything and everything else.”
Investors reacted to the potential loss of this support like trust-fund kids warned that Daddy is about to cut off their allowance. They panicked. What is striking is the breadth of assets that have fallen in price in recent weeks (see chart). Equities have dropped around the globe, with some markets (including China’s) now 20% below their recent peaks.
Government bonds have suffered: yields have risen sharply in safe, liquid markets like America and Germany, in troubled euro-zone members such as Italy and Spain, and in developing countries. And there has been a rout in the gold and silver markets, as well as a sell-off in economically sensitive raw materials such as copper.
Why would a reduction in the pace of QE by the Fed be a global problem? Other central banks may compensate, after all. The Bank of Japan has started a programme of rapid monetary expansion. There are hopes that Mark Carney, the new Bank of England governor, will ease policy. Some believe that even the European Central Bank will eventually be forced into QE.
One issue is the dominance of American investors on the global stage. As Jim Reid, a strategist at Deutsche Bank, comments: “The problem we face is that the US tends to set the price of debt everywhere.” With the yield on ten-year Treasury bonds rising by a percentage point since early May, other yields have been forced up in tandem. The effect is a global tightening in monetary policy. A spike in Chinese money-market rates has not helped, especially as investors were already concerned about a slowdown in Chinese growth.
What makes the markets harder to read is that bond yields are rising even though global growth forecasts have been revised lower and inflation is generally falling. This may reflect the determination of investors to stay one step ahead of the authorities. Rationally, if the end of QE is bound to result in a huge rise in yields, it makes sense to sell now rather than later.
But if yields rise far enough to dent the economy, or if stockmarkets collapse and undermine consumer confidence, the Fed may be forced to keep QE going. (That explains why shares rose on June 26th after a downward revision to America’s first-quarter GDP.) “Markets tend to test things,” Richard Fisher of the Dallas Federal Reserve told the Financial Times this week, comparing investors to “feral hogs…If they detect a weakness or a bad scent, they’ll go after it.”
The potential withdrawal of QE support also forces equity investors to focus on the fundamentals, which are not that supportive. According to Citigroup, downgrades of earnings forecasts are outpacing upgrades by a ratio of three to two. Equities look cheap relative to government bonds but not in their own right: the cyclically adjusted price-earnings ratio on the American market is 23.6, well above the historical average.
It is possible to put a positive spin on all this. The Fed’s hints of a “tapering” of QE, and the subsequent rise in bond yields, may simply signal a return to normal. Although growth in developing countries seems to have slowed, there have been better signs in the rich world: a good first quarter in Japan, falling unemployment in America and even glimmers that the worst may be over in Europe.
The more bearish possibility is that the developed economies will struggle to maintain momentum if emerging markets are slowing; that the rich world has still not managed to reduce its high debt levels; and that the sell-off represents a recognition by investors that they are in deep trouble without the crutch of central-bank support. It is a nice irony that the titans of fund management, who consider themselves robust champions of the free-market system, are so dependent on handouts from the monetary authorities.