Tuesday, November 19th, 2013

When the Fed tapers

No-one knows when the Fed will start the taper, but it is bound to have some unexpected and unintended consequences. Here are three which may be interesting and important.

International diversification may not work. Regular readers of this note should know that the returns of US Equities and Treasuries have been positively correlated since late summer. The rolling 26-week reading is now up to +47% which compares with a median figure of -22% for the period 1995-2012. The decisive change in the data occurred in late May, when Chairman Bernanke first talked about tapering QE. Correlations can change, but the best and most likely interpretation of this data is that US Equities and Treasuries will go down together when the taper starts. The other issue is that the dollar-denominated returns of several Non-US Equity markets (Europe, UK, Emerging Markets) show even higher positive correlation with US Treasuries (typically 50-55%), which means that diversification into international equity markets is unlikely to be a successful strategy for US investors.

Rising yields boost corporate investment. Investors naturally regard rising yields as a threat to asset valuations, but the second order effects can be much more complex. Data from the UK Pension Protection Fund suggests that large UK employers will spend £28bn in extra contributions in 2013-14 to reduce the deficit on their defined benefit pension schemes. This is money that could otherwise have been re-invested in the business (gross investment by the whole of the private sector in 2013 is estimated at £125bn). So rising yields could materially increase the ability of UK firms to boost capital expenditure, and the maths is likely to be similar for defined benefit plans in the US and Europe.

Commodity prices fall. If, like us, you believe that QE was one of the main causes of the second boom in commodity prices from 2009-11, the logical corollary is that they should fall when QE is reduced. In most developed economies inflation is remarkable by its absence (excluding trophy assets like Mayfair houses and paintings sold by Christies) so the hedge against inflation argument is irrelevant, if not actually misconceived. Rising yields mean higher holding costs. If holders believe that prices can go down (just look at a chart) their incentive is to sell before the rest of the market. Commodities like copper and gold are not important for the real economy, but energy is. We note that oil futures have fallen by 14% since late September. It is too soon to call this a trend, but there is a possibility that the taper could exert downward pressure on oil prices – and that would quickly boost the purchasing power of US consumers.

Whenever it comes, the taper will have many unintended consequences. We foresee a period of considerable difficulty for asset allocation, but certain impacts on the real economy may be actively beneficial. Companies may have more capital to invest, and consumers may have more discretionary spending power.


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