ECM Asset Management’s Jens Vanbrabant reviews a summer of market and policy changes

Jens Vanbrabant, lead portfolio manager at ECM Asset Management, has reviewed the effect that US Federal Reserve moves to taper its QE programme has had on markets, rates and currencies over the summer period.

When chairman Bernanke announced on 22 May 2013 his intention to reduce to zero the monthly amount of treasuries and mortgage backed securities the Fed buys by the middle of 2014, investors across the world sensed it was a momentous occasion. After Operation Twist, a set of new currency swaps with foreign central banks, QE3 and finally QE to infinity, this was the first time since the market convulsion in the summer of 2011 that the world’s most powerful central bank acknowledged that the US economic recovery was gathering sufficient momentum to allow a tightening of extremely accommodative monetary policy.

The prospective withdrawal of stimulus and the resulting back up in US interest rates has hit emerging markets (EM) most forcefully, as hot money that has been flowing in search of yield in the equity and bond markets of these economies has quickly repatriated to the safer shores and rising rates of the US. In particular, those emerging markets which are running a current account deficit have been the biggest victims as investors fear that attracting international capital will become much more difficult and expensive.

So far, countries like South Africa, Indonesia, Turkey and India have suffered most. Let’s have a closer look at the largest of these, India. In an effort to stem capital flows out of the country, authorities have raised tariffs on the import of gold, supported domestic banks and imposed capital controls on both Indian companies and individuals. Nevertheless, the rupee fell to a record low against the USD of 65.5 yesterday as financial market participants doubt the effectiveness of these measures. By using capital controls, India has increased concerns that it may be willing to go as far as preventing foreign investors from taking their money out of the country, as Malaysia did in 1998. By selling US Treasuries to protect the rupee and buy back long dated local currency government bonds from ailing domestic banks, the central bank has locked in capital losses and depleted its FX reserves by 5.5% according to Morgan Stanley.

The disappearance of current account deficit EM central banks as a buyer base of US Treasuries means there is one less marginal buyer of Uncle Sam’s bonds. To an extent, Federal Open Market Committee (FOMC) members will be pleased with this as they are trying to prevent the fixed income bubble from inflating too much, but this potentially makes the sell off all the more painful for remaining holders of Treasuries.

Our summer trip around the world does not end in India as it is not just EM and Treasury investors who are impacted by these developments. Messrs. Draghi and Carney in particular also find themselves in a tight corner. Just when they take the unprecedented step of providing forward guidance in an effort to stimulate European economies by keeping domestic rates lower for longer, gilts and bund yields are being dragged higher by the rising Treasury rates: 10 year gilts are now 25 bps higher than when Mr. Carney announced his guidance on 7 August 2013 whilst 10 year bunds are 22bps wider than on 4 July 2013, the day of Mr. Draghi’s speech. For now, they have been reassured by positive GDP growth in the second quarter and by strong July Services and Manufacturing Purchasing Managers’ Indices, (PMIs) but more sceptical market participants are interpreting the higher European rates as an early sign of the limits of QE and forward guidance. They fear that markets could grab the steering wheel by forcing interest rates higher.

More broadly, the bears also cite a number of challenges that the markets will have to face over the coming months. In the US, the taper decision in September and the debt ceiling discussion are front and centre on their minds. In Europe, the German elections, the German constitutional court’s decision on the legality of the Outright Monetary Transactions (OMT), the political instability in Italy and Spain and the increasing chatter about new bail out packages for Portugal and Greece all have the potential to cause volatility.

Nevertheless, until now one has to recognise that central banks remain in control, the retreat in developed market government bond markets has been orderly and that European equity or credit markets are continuing to behave well. The safest place in fixed income markets remains duration hedged or floating rate credit: the Euro and Sterling denominated interest rate hedged credit indices are up 0.3% and 0.7% respectively this month versus total returns of -0.4% and -1.2%, continuing a trend of outperformance that we have seen all year.

Meanwhile, dollar denominated credit is starting to look cheap. For instance the 10 year USD denominated BBB- rated bond issued with a coupon of 3.375% in October 2012 by Turkish brewer Anadolu Efes now trades at a cash price of 80 which corresponds to a yield of 6.1%. The broad US investment grade corporate bond index trades at a yield of 3.5%, implying positive real returns of 2.3% after deducting US inflation of 1.2%. Worth buying? We prefer to spend the rest of our summer holiday away from these temptations. Cheapness on its own is not enough to re-enter the market, this bond and many similar ones will be a bargain when the rise in Treasury yields reaches a ceiling. Until then, we remain positioned in developed market credit and in safer areas of the EM complex, in particular surplus countries such as Russia and the Middle Eastern states.

 

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