Why markets fear tapering
Matthew Sutherland April 14, 2014
There’s nothing more likely to kill the buzz at a party than the alcohol running out. If the punchbowl
is taken away before the party gets going, you can be sure the guests won’t stick around very long.
That’s why markets are worried that Janet Yellen, the Chairman of the US Federal Reserve, will take
away the punchbowl of loose money before the economic party has got going again in the form of
GDP growth, inflation and job creation.
Markets wouldn’t mind so much if the party was already going strong, and we already had solid
growth, inflation returning to the system, and high levels of job creation. The problem is that right
now we only have one of those things - economic growth – and even that is anemic by pre-crisis
standards. There is no real job creation going on. Most unemployment data is flattered by the fact
that millions have become structurally unemployed and are no longer participating in the workforce.
Rapid technological innovation has replaced many manual and low-level clerical jobs with robots and
computers and will continue to do so. Combined with plenty of spare industrial capacity, this means
there is little upward pressure on prices. It seems too early to take away the booze.
The Federal Reserve and other central banks have been providing the punchbowl by expanding the
money supply ever since the global financial crisis of 2008. The aim was to prevent the world sliding
into deflation in a repeat of the Depression of the 1930s. They were right to do so – no-one knows
how bad things might have become had they not. But the difficulty is how and when to stop, given
that the partygoers have become addicted to the punch. The combined balance sheets of the
Federal Reserve, the Bank of England, The Bank of Japan, and the European Central Bank have
grown by US$6tr since the start of 2008, and are still growing.
This monetary expansion has fuelled asset price inflation as the new money seeks a return. That’s
why we have seen such great performance from almost all asset classes since 2008 –bonds, equities,
property, wine, and art have all gone up hugely since 2008. Yet there has been no such increase in
consumer price inflation, or CPI. CPI, which attempts to measure the cost of a standard household
“shopping basket” of goods and services, has remained very benign globally, at less than % in
most major developed economies. Some countries, such as Spain, are still flirting with outright
deflation. So why does expanding the money supply create asset price inflation but not CPI inflation?
The answer lies in deleveraging. Governments, corporations and consumers were all shocked by the
extent of the 2008 crisis. Like Asian governments after the Asian currency crisis of 1997, everyone
has resolved not to make the same mistake again. As part of the cause of the crisis was excessive
leverage, everyone has decided they need to deleverage. Deleveraging is highly deflationary,
because every time you make a dollar, you save it (or invest it) rather than spend it. Demand for
goods and services falls. CPI inflation is a function not just of the amount of money in existence, but
the speed with which that money changes hands – sometimes referred to as “money velocity”.
Money velocity has been falling dramatically in all countries globally. Every dollar the central banks
print is being squirreled away or invested in a long term asset. This is why asset prices rise but CPI
does not.
A worrying result of this phenomenon is the swiftly widening gap between rich and poor. This is a
global phenomenon, as true in rich countries as in emerging ones. The owners of assets have done
fantastically well, as the prices of those assets have skyrocketed on the rising tide of monetary
expansion. But those who don’t own assets have fared far worse. They, clearly, have had no benefit
from asset price inflation. At the same time, they have at best seen no wage inflation, and at worst
lost their jobs, probably to a robot or a computer.
The beneficiaries of this – the asset owners - are small in number. The top 1% of the world’s
population by wealth owns an amazing 46% of the world’s assets. Meanwhile, the bottom half of the
world’s population by wealth owns nothing at all – they live hand to mouth. At what point do they
cry “enough is enough”? We are already starting to see signs of increasing social unrest on the
world’s streets, and this remains a key risk to markets in the next few years.
So ideally, before Ms Yellen and her peers turn off the printing presses, it would be preferable to see
some real job creation putting some upward pressure on wages. Additionally it would be good to see
some evidence of deleveraging having run its course, through consumers being willing to spend
again instead of saving; corporations being willing to spend money on capital expenditure; and
governments no longer taking an austere approach to balancing their budgets. As yet we see little
evidence of any of these.
The fear of central bankers is that if we wait until we see the evidence, it will be too late to remove
the punchbowl because of the lagged effects of monetary policy changes, and the result could be
high, or even hyper, inflation. So they want earlier, more aggressive action. The fear of markets, on
the other hand, is that central banks will try to anticipate a recovery in these items which would not
in fact actually be forthcoming, and thereby stall the global economic recovery. So they want later,
more gentle action. This is why markets get jittery when the Fed looks more hawkish at the margin,
and breathe a sigh of relief when it looks more dovish.
Meanwhile, on a somewhat separate topic, we are seeing some dramatic rotations in equity markets.
The first is a rotation from developed markets to emerging markets. In the month of March we saw
foreign inflows into all the Asian emerging markets – the first month in which this has been true for a
very long time. Dedicated Emerging Market funds had their first inflow week in the last week of
March after 22 consecutive record outflow weeks. One might think this strange, given fears over
tapering of quantitative easing, and geopolitical events in Ukraine. But the fact is that despite those
things, indicators of risk such as the VIX index remain very low. As discussed earlier, we certainly still
have ample global liquidity. And after extended periods of underperformance, many emerging
markets were looking good value again, especially those with relatively sound fundamentals such as
China and Korea.
The second big rotation we have seen is from growth stocks into value stocks. This too has been
quite dramatic and quite sustained. This “factor rotation” (from one investment “style” to another)
has caused the substantial decline in technology sector share prices in China, the USA and elsewhere,
as investors seek to lock in gains in high priced growth stocks and rotate into less favoured sectors
that seem to offer better value. On 3rd April, the Russell 1000 sales-to-price factor, one of the key
“value” categories, had a positive 3 standard deviation return, reflecting a huge flow into the value
area.
In my view, both the current rotation into EM and the current rotation into value are likely to prove
to be tactical and temporary rather than structural and permanent. There are good stocks to be
found in both the growth and value areas, and in developed markets as well as emerging. The key
conclusion, as ever, is that investors need to do their research (or hire someone who can), because
in the long run picking the right stocks, sectors and markets is all down to good bottom-up analysis.
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