24th July 2013
Axa Investment Managers has put together a report into the normalisation of monetary policy in the US. With tapering starting most likely in September and expected to be wound down by mid-2014, it is probably the most significant issue facing markets and something investors need to bear in mind as part of their asset allocation decisions.
This is doubly the case if you intend to make any tactical tweaks to your portfolio. And if you have ‘sub-contracted’ those decisions to your financial adviser or a multi-asset discretionary fund manager, it won’t hurt to know some of the things they are confronting.
Eric Chaney, head of research, AXA Investment Managers has written a lengthy report on the matter, but distilled it into ten points, which we print below.
1) The first stage of monetary normalisation, QE tapering, should probably start in September, with QE expected to be over by mid-2014. This tapering is Act One of a three-act drama.
2) Liquidity injections during the Fed’s QE programme have moved asset prices away from their fundamental dynamic equilibrium, to which they will most likely return. That the end of QE is contingent on a better state of the US economy sounds to us like a “Bernanke put”.
3) QE3 largely explains the substantial re-rating of developed market equities since September 2012. US equities are now overvalued by roughly 7% compared to fundamentals, European equities by slightly less than 10% and Swiss equities by more than 15%.
4) Similarly, US treasury yields are around 50 bps below our estimated fair value based on fundamentals.
5) Looking forward, the end of QE should push US bond yields higher, albeit in all likelihood moderately in the first stage. We still expect 10Y US yields around 2.5% at the end of this year and reaching 3% or more by end 2014.
6) The end of QE should prove positive for US equities, with an annualised return of around 10% by the end of 2014, thanks to the stronger economic fundamentals which are a condition to end QE (the “Bernanke put”).
7) In Europe, bond yields should also rise but less so. Despite less favourable growth prospects, European equities should perform as well as in the US, thanks to a higher beta.
8) We believe emerging market currencies and assets, which had been strongly supported by capital inflows from the US during QE, will be the main casualties of the end of QE. More currency depreciation relative to the USD is in the pipeline for several emerging market currencies, should investors continue to roll back their investment as liquidity from QE wanes.
9) Emerging market equities will continue to suffer, but not all markets are equal. Emerging Asia valuations offer a welcome buffer, but a country like the Philippines remains vulnerable. Latin America is still overvalued by more than 15% compared to its fundamentals. Weaker fundamentals in Brazil make the market vulnerable to a further correction.
10) Once QE is over, markets will focus on the future path of short-term rates during the second stage of monetary normalisation, as well as the inflation risks associated with the legacy of the crisis i.e. a monetary base four times as big as it was before the crisis (though this could come later). Shrinking the monetary base will be the Third Act of the drama.