Quantifying the QE experiment
All good things come to an end…like quantitative easing (QE). The original term ‘Grexit’, coined to describe the fear that Greece might leave the euro, has now inspired the neologisms ‘Brexit’ (concern about Britain quitting the EU) and ‘QExit’ − the threat that the Federal Reserve (the Fed) will cut back on QE.
At present, the Fed’s QE programme means it spends $85 billion a month on buying bonds ($45 billion on longer term US Treasury bonds and $40 billion on mortgage backed securities [MBS]). Last December, the Fed made clear that it expected ‘to continue asset purchases until we see a substantial improvement in the outlook for the labour market.’
Ben Bernanke, the Fed chairman, went on to explain that the yardstick it was looking towards was an unemployment rate of 6.5% (the rate is currently 7.6%), provided inflation remained within target (no more than 2.5% one to two years ahead).
On 22 May, Mr Bernanke gave a speech to the US Congress in which he said that the Fed was considering “whether a recalibration of the pace of its purchases is warranted” − in other words, ‘tapering’ that $85 billion a month of bond-buying. The comment, which arrived at much the same time as disappointing growth figures out of China, upset the markets. The following day saw the Nikkei 225 drop 7.3%, accompanied by less dramatic falls in other global equity markets. That volatility has continued subsequently, although over the month of May as a whole most stock markets posted gains (even the Nikkei was down less than 1%).
Bonds had a rough month, and for May the IMA bond fund sectors were underperformed only by the two Japanese sectors (dragged down more by a sinking Yen than share price movements). US ten-year Treasury bonds started May with a yield of 1.67%: by the end of the month the yield was 2.17%. US MBS also took a hit on fears that the Fed would ease its purchases, and as a result US 30-year mortgage rates rose to around 4%: they were 3.31% last November. UK gilts were not immune from rising yields − the benchmark ten-year bond yield rose from 1.69% to 2.03% in May and, at the end of June, was close to 2.2%.
The markets have two main concerns: when will the brakes start to be applied to QE and, more importantly, what will be the impact? QE has been an extensive monetary experiment and the jury is still out on what it has achieved. In one camp are those who think QE has prevented a recession becoming a depression, while in another camp there is a belief that QE has simply pumped up markets with an excess of liquidity, driving down bond yields to unjustifiably low levels. If the latter view is correct, then the corollary is that when the Fed starts to turns off the cash tap, markets will suffer.
EMF ‘exodus’ continues as investors drop stocks and bonds
Investors were still pulling money out of emerging market funds (EMFs) in early June, according to EPFR Global, although recent declines in other asset classes slowed.
Globally, more than US$3 billion was withdrawn from emerging market equity funds during the week ending 19 June, while withdrawals from emerging market bond funds hit a 90-week high as the ‘exodus’ from these regions continues.
The so-called BRICS (Brazil, Russia, China and South Africa) suffered the most, as investors took their money out of funds focused on top-tier emerging markets. However, investors maintained interest in frontier markets, where funds in these markets have had net inflows every week since mid-March. In spite of the funds taken out of EMFs, investors added to equity portfolios in general ahead of the Federal Reserve monetary policy meeting on 18 −19 June. Overall, equity funds benefited from US$4.81 billion in fresh money over the working week ending 19 June.
The pace of outflows from bond funds was nearly half of the record US$14.45 billion seen in the previous week. EPFR Global says this suggests investors expected the outcome of the Fed’s meeting to be ‘relatively benign’, although it turned out that chairman Ben Bernanke said quantitative easing could slow if the US economy continues to gather pace.
EPFR Global research director Cameron Brandt said: “The Dow’s 354 point drop the day after Fed chair Ben Bernanke statement indicates investors did not get what they were looking for from the US central bank. With the second of the year’s four ‘triple witchings’ [or the simultaneous expirations of some futures and options] and China’s banking system getting fresh scrutiny, we think there is a good chance of big swings in fund flows during the coming week.”
The latest Bank of America Merrill Lynch Fund Manager Survey shows asset allocators’ weightings to emerging markets ‘collapsed’ during June as investors took a net 9% underweight to the region. Just four months ago, a net 43% of fund managers had an emerging market overweight, but 32% now rate a so-called hard landing in China as their top tail risk.