Over the last six weeks, global asset prices have experienced a period of heightened volatility as investors have been forced to confront the consequences of a possible change in US monetary policy. The initial trigger was Fed Chairman Ben Bernanke’s congressional testimony in May, but the real damage was done following his subsequent news conference where, for the first time, he gave guidance over the timing of a possible withdrawal of Quantitative Easing (QE).
Although few will have been completely surprised by Bernanke openly discussing his views on a possible tapering of the programme, his provision of a timetable that included a potential termination date has unsettled many.
The ensuing sell-off has seen losses across most asset classes as investors have sought to exit those investments seemingly supported by current Fed policy. High yield equity, bonds and commodities have all been casualties, in some cases retracing all of the year’s previous gains. In our view this reaction is both inevitable and healthy, helping to create a more stable and robust base upon which markets can build.
Market misinterpretation of Bernanke’s comments
In order to assess the nature and timing of any possible recovery, it is important to analyse exactly what Bernanke actually said and what, in all probability, he meant. Reading the full script of both his news conference and his early congressionally testimony it is clear that the market has misinterpreted a critical part of his message. Both speeches clearly link the future path of monetary policy to the pace and durability of the economic recovery. This is a point that other members of the Federal Reserve have subsequently been at pains to point out. There is nothing mechanistic about potential withdrawal; it will only happen when and if economic conditions justify it.
In this context it is worth pointing out that while Bernanke’s comments were made against a backdrop of an improving economy, the pace of recovery is by no means assured. The continuing congressional impasse that has stymied attempts to resolve the Government debt ceiling could reduce GDP by as much as 1% this year, while the recovery in house prices could be swiftly threatened if mortgage funding costs continue to rise.
Why was Bernanke’s message so explicit?
So if the decision over possible tapering remains finely poised why did Bernanke go to such pains to provide investors with such a seemingly explicit message? The answer to this lies in the way in which asset prices have been behaving since the announcement of QE3 last September. Equity and bond markets have become highly correlated, performing strongly and arguably disconnecting from investment fundamentals. While it is probably too emotive to describe the move in bond markets as a bubble, the growing disconnect between bond prices and economic returns was clearly building up the prospect of future trouble should the trend be allowed to continue. By acting early and decisively in warning investors of the folly of relying on Fed policy to support their investment decisions, Bernanke has done much to alleviate far more significant future problems.
The outlook for investors
While we see recent price movements as removing a lot of the valuation excess, we would view the move in bond markets in particular as part of a longer-term and sustained trend towards higher yields. Macroeconomic uncertainties and weakening growth in China may avert this trend for a period, but we would expect yields to gradually normalise over the next two years.
In contrast, this trend towards normalising interest rates driven by improving economic conditions should help first sustain and then improve the outlook for equities. Valuations here do not looked stretched despite their recovery, supported as they have been by improving corporate profits. While the summer months may well be beset by further volatility, this is now far more likely to be engendered by fears over Chinese growth rates than reversal of US monetary policy. In our view equity markets have just cleared another of the major obstacles on the path to normalisation; this at least is a reason to be positive.
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