The next Fed meeting is scheduled for 18 19-September. The possible decision by Ben Bernanke on the start of tapering, ie the gradual reduction of the monetary injection plan (Qe) which passes through the purchase of 85 billion dollars a month of securities, is under the eyes of the market. Axa in a recent report edited by Eric Chaney they say they are quite convinced that purchases will be reduced gradually but steadily between September 2013 and June 2014 and outline the effects that this process will have on the various asset classes.
On the other hand the phase of quantitative easing cannot last forever. The measures put in place by the Fed also have negative consequences: they distort the prices of all financial instruments, not just government bonds; by reducing the cost of risk, they fuel unwanted price bubbles and amplify moral hazard; moreover, the infinitely protracted purchase of government bonds could lead to a monetization of public debt such as to cause a serious inflationary risk. However, what worries the markets in this phase of the exit strategy is the lack of historical references capable of guiding the political authorities, which represents an obvious source of uncertainty.
LIQUIDITY EQUILIBRIUM VS FUNDAMENTAL EQUILIBRIUM
What will be the effects on the main investment asset classes? To understand it, you must first remember which it's where the markets are now and how they got here. Axa explains: "The massive injections of liquidity by the Fed have driven up the prices of financial instruments higher than what the fundamentals would indicate, bringing to mind the famous saying that high tide raises all boats". In other words, the substantial appreciation of the equity markets since September 2012 is mainly explained by the effects of the third phase of quantitative easing (Qe3) which pushed the markets to a liquidity-based balance, i.e. artificially inflated by the portfolio rebalancing effects induced by quantitative easing. Thus moving the quotes away from the second type of possible balance, the one driven only by the fundamentals, for example earnings for stocks and default rate for credit.
THE EFFECTS OF QE ON PRICES
On the government bond front, Axa's estimates are in line with those of the Fed whereby the negative impact of the quantitative easing plan on 10-year yields in the United States is between 65 and 120 basis points. On the equity front, Axa estimates the cash-driven balance is 10% higher than the fundamentals-driven balance in the US (assuming US corporate earnings growth of 7% over the next 12 months). In European equity markets the gap is smaller, with the exception of Switzerland where it is over 15% due to the defensive nature of the Swiss market. "The cyclical uncertainties - explain the Axa analysts - could have amplified the impact of liquidity".
UNCERTAINTY AND VOLATILITY
June's announcement about Bernanke's possible introduction of tapering upset the balance on liquidity. "Since investors realized that the third phase of quantitative easing could close - explains Axa - the markets have undergone a correction by converging from a balance based on liquidity to a balance based on fundamentals". At the moment most of the markets fluctuate between these two equilibrium points, with the return of volatility for all investment categories, linked to the uncertainties on the timing and calibration of the gradual reduction phase of the plan. On the other hand, notes Axa, “an increase in volatility for all asset classes is a consequence of the normalization of monetary policy, a reflection of the volatility compression caused by the purchasing plans”. And the normalization of volatility will continue to have an impact on instruments considered riskier, such as emerging markets, as the risk measurement bias has led investors to take positions they otherwise would not have taken.
THE CURRENT SITUATION OF THE DIFFERENT ASSET CLASSES
With a return of around 2,5% treasury bonds American are found for Axa about 50 basis points below of fair value, whereas a month ago they were more than 100 basis points lower. Similarly, US stock markets are now approximately 7% overvalued relative to fundamentals, versus 10% previously. Conversely, investment grade credits are broadly in line with fundamentals thanks to the recent correction on both sides of the Atlantic. Conversely, in Asian equity markets, the liquidity-driven balance is more than 10% higher than the fundamental-driven balance in emerging Asian countries. “This figure – explains Axa – reflects the size of equity fund flows to Asia (excluding Japan) in the first 6 months of the third phase of the quantitative easing plan (close to 10% of the NAV of equity funds in emerging markets in Asia based on Epfr data), even if these flows have since partially reversed the trend". For Latin America, the equity valuation gap is now less than 5%: the strong outflow of equity funds since February has reduced the impact of quantitative easing in the region. Nonetheless, the area remains overvalued relative to the two equilibrium points driven by fundamentals and liquidity.
THE IMPACT OF TAPERING ON ASSET CLASSES
Axa believes that US bond yields will most likely rise moderately once the easing package closes. According to Axa's analysis, in fact, the announcement of the closure of the quantitative easing plan started a prolonged phase of increasing long-term interest rates in the United States and in all the other countries influenced by monetary policy. Thanks to strengthening economic fundamentals, we should see a recovery in US equity markets and a tightening of credit spreads. In Europe, bond yields should rise, albeit to a lesser extent, while equity markets should report positive results like in the US thanks to a higher beta. Finally, for Axa, currencies and financial instruments in emerging markets will continue to be the main victims of the closure of the quantitative easing plan. Let's see in detail each individual asset class.
BONDS
USA. US 10-year yields will rise more than 3% by the end of 2014. "With the reduction in the purchases of securities by the Fed - explains Axa - long-term yields should rise as the effects of the flow of purchases and the compression of term premiums will disappear". The 3% yield could even be higher if markets reflect lower rates than our estimate of a target fed funds rate of around 1% by the end of 2015. At the end of 2013, however, Axa's target yield at ten years is at 2,5%. “We suggest taking advantage of the opportunity deriving from any yield declines to reduce duration”, say the Axa analysts explaining that they currently have an underweight position in medium-term US treasuries. “The Fed wants to orchestrate a very slow rise in yields – they explain – A faster adjustment would not be appropriate as the recovery remains irregular and inflationary expectations contained”. Long-term rates should instead fall between 3,5% and 4,5% in 2015-2018, “As most of the assets in the Fed's portfolio mature (2016-2022), the US central bank's balance sheet should gradually tighten as conventional monetary policy becomes paramount again.”
EUROPE. As for Europe, rising yields in the US will affect European bonds given the historical correlation between the two markets. Axa expects the yield differential between US Treasuries and German Bunds to widen further and a revaluation of the dollar against the euro. But the end of the stimulus, notes Axa, "will not directly affect the spreads of peripheral countries which depend on idiosyncratic factors". However, adds Axa, "the increase in yields on all maturities could question the credibility of the fiscal measures and cause a widening of sovereign spreads".
BERNANKE'S PUT OPTION AND ACTIONS
USA. The closure of the plan favors corporate fundamentals in the US. “The expected increase in bond yields in itself is not bad news for risky assets, especially for equity markets,” comments Axa who notes that their analyzes indeed show that PEs have a positive correlation with bond yields Treasury for yields below 5%. Furthermore, Axa believes that this time the dynamics of the end of Qe1 and Qe2 will not recur for the equity markets (with a correction of the S&P of 15% and 23% respectively). “In our opinion this time is different – explains Axa – the FOMC will have to record a significant improvement in the labor market before adjusting the volumes of asset purchases. This condition implies that the closure of the plan benefits corporate earnings in the United States. In other words, there is no causal link but a common denominator which, if it occurs, would lead to both a reduction in asset purchases and an upward revision of earnings.
“The conditions envisaged by the Fed – adds Axa – should therefore ensure that the gap between the liquidity-driven balance and the fundamental-driven balance is not excessively large at the end of the quantitative easing plan. Let's call it Bernanke's put option”. Thus, if one calculates 12-month forward earnings growth of 15% rather than the 7% consensus expects, in the absence of Fed liquidity injections, the result (the fundamental equilibrium) is broadly in line with the current ratings. In other words, says Axa, “the market is presenting fair valuations at the moment, even assuming the closure of the easing plan. Conversely, if the conditions for closing the plan are not met, the injections of liquidity will continue, favoring equity multiples. Axa thus expects an annual return on US equity markets of more than 10% over the next two years, confirming the positive prospects for equities.
EUROPE. “However – specifies Axa – this free option offered by the Fed applies to risky assets in the US, not to foreign markets, since conditions affect the US economy and there is no guarantee that the fundamentals of other regions will be positive enough to limit turbulence during the transition phase”. Thus volatility will remain high in both Europe and emerging markets. In particular for Axa the current valuations of European shares are slightly expensive compared to the equilibrium driven by fundamentals but analysts nonetheless forecast a gradual economic recovery in the region during the second half of the year which should favor a rebound in earnings to which is added the positive impact deriving from a strengthening of the recovery in the USA. "The prospects - concludes Axa - therefore still seem constructive for the European markets in a scenario in which the US economy accelerates enough to justify the closure of the easing".
EMERGING. Emerging markets, on the other hand, will continue to suffer, especially those that are overvalued and/or have recorded a large collection after the first phase of quantitative easing in 2008, also because volatility pushes investors to review their risk positions. If investors continue to reduce investments as the liquidity injected by the Fed decreases, according to Axa analysts, emerging currencies will still devalue against the US dollar. On the equity front, certainly not all markets are created equal. If Asia is a good buffer, because poor year-to-date results have kept multiples below fair value (even in the event of a QE plan closure, plus Japan plan should compensate) , a country like the Philippines “remains vulnerable to the extent that it has attracted large amounts of capital to equity funds (over 100% of NAV in the last 12 months) and is now highly overvalued”. For Axa, Latin America is also still overvalued, more than 15% compared to the fundamentals. Finally, Brazil remains vulnerable while “Mexico could benefit from conditions imposed by the Fed thanks to its robust exposure to the US economy”
