Tuesday, September 24th, 2013

The Candy Men

The Fed’s decision not to begin the taper last week was another sugar rush for investors and equity markets round the world responded like six-year olds at a birthday party. The Fed clearly has a problem in working out whether equity market strength is a side-effect of its policy or one of the main transmission mechanisms. After the recent communications failure there is little point in trying to uncover which economic variables have to hit what level before the policy is changed. We know it will happen within the next six months, and it is much more important to work out what the investment landscape will look like when the taper finally starts.

For some time we have been drawing attention to the weeks when all the major asset classes moved in the same direction. Last week was a collector’s item, US equities were up 1.3%; every other region was up between 1.0% (UK) and 3.7% (Eurozone). Of the forty countries which we follow only the Czech Republic and Greece posted a negative return in dollar terms. On the fixed income side, 7-10 year Treasuries rose 1.4% and everything else from High Yield to Investment Grade to REITS was up by 1-2%. Cue Ben Bernanke and chorus singing, “The candy man makes / Everything he bakes / Satisfying and delicious / Talk about your childhood wishes / You could even eat the dishes.”

The problem with this is that the dollar returns of every major equity region are now positively correlated with medium-term US Treasuries. For the UK, the Eurozone and Emerging Markets this number is now above the 40% level which most people regard as statistically significant. For US equities the figure is 32%. The only reason the number is not higher for Japan (18%) is that the dollar yen rate has been highly volatile.

These numbers are based on 26-week rolling data, not the usual 52-week measure. The reason is that it is only 20 weeks since Mr Bernanke first mentioned the idea of tapering. Everything before that time belongs to a different regime. In the new pre-taper world, and in the immediate aftermath, equities and bonds are likely to go up and down together. The longer we wait for the taper to start, the more powerful and potentially dangerous these positive correlations will become.

If every six-year old has too much birthday cake, the chances are that they will all be sick before the party ends.



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