Ever since the world’s major central banks first started their various programs of liquidity injection and asset purchase, financial markets have for the most part existed in an odd world where, paradoxically, bad news on the economy was believed to hail increased asset purchases and therefore was positive news for the prices of equities, credit and sovereign debt.
As most readers will know, this paradigm was shaken in May and June of 2013 as the Fed revealed to markets the circumstances under which it would begin to “taper” the level of asset purchases. Government bond yields around the world rose, and equities (both developed and emerging) sold off.
Given this background each Fed announcement (such as last night) is treated as potentially significant market event where new information on the potential pace of tapering may be released to the markets with implications for both equity and government bond prices.
What happened on Wednesday?
for those that don’t already know, on Wednesday the Fed opted to continue to maintain (for now) the current level of asset purchases. Market consensus had clearly moved to expect a small reduction in the level of asset purchases of approximately $10-25bn per month. Markets responded in the obvious way with equities rallying and fixed income yields lower.
However, the moves in asset markets were small, in the context of the moves seen since May (the US 10 year yield fell c20bps vs 140bps of increases since May, the UK 10 year fell around 10bp vs around 100bp of increases since May with the long end of the UK more muted). Developed Equity markets were up 1-1.5%, from levels which in some cases (such as S&P 500 and Eurostoxx) were already above the pre-May 2013 levels.
The VIX, which has been remarkably range bound compared to recent history in the 11-15 range for most of the year with only the relatively modest tick up to 20 during June,continues to sit in the middle of that range.
What does this tell us?
The first thing yesterday’s moves highlighted is the danger of getting too carried away with market concensus in a paradigm where policy headline “bombs” can still dominate asset price fundamentals, in either direction.
Having said that, we can now say with reasonable confidence that markets have priced in some level of Fed tapering, but the exact timing of this (which is uncertain) is less significant than the fact that it will happen, broadly over the next couple of years.
Equities have “got over” the fact that stimulus will be removed and subject to small surprises around the exact timing will move back to a paradigm where the response is driven by reaction to genuine changes in the global economic and inflation outlook.
Fixed income markets have priced substantial “normalization” of base rates rises into the medium term future, while current base rates are still at record lows. This means yield curves are steeply upward sloping. While the risk of further rises in medium and long-term interest rates of course remains a significant risk, the level of base-rate rises priced also raises the possibility of disappointment relative to what’s priced in. Risks to interest rates remain 2-way.
Another point worth noting is that given the steepness of the interest rate curves in both the US and the UK, there is a significant roll down and carry premium associated with a medium term duration position, against which you have the risk of rates rising further.
What does this mean for institutional investors and pension funds?
1. Setting pension fund investment strategy is about managing risk and return within sensible parameters over the long term without placing too much emphasis on shorter term tactical or valuation considerations. The dynamic that has existed across markets in recent years has often focused investors minds excessively on the events that might surround the removal of stimulus, and therefore on relatively short term and value concerns, which should not be the primary consideration at the pension scheme level. An end to this environment should definitely be welcomed by pension funds as an opportunity to move on from this situation and back to a genuine focus on investment risk and return in the long term.
2. The effect of asset purchase stimulus (or its removal) has been to force many markets (particularly equity, sovereign debt and commodity) to move in the same direction – either up or down. This increase in correlation has caused short term increased volatility for investment strategies designed according to sound diversification principles. A move back to normality where the more fundamental and long-term asset classes relationships hold will bring the risk-adjusted return of well-diversified investment strategies back to long-term expected levels.
3. Another consequence of the “QE era” has been the punishing of asset managers who may have been on the right side of fundamentals, but the wrong side of the policy announcements, granted one might argue that fund managers should have recognised that managing money in this environment was about forecasting policy changes rather than the fundamentals themselves, but either way a return to a fundamentals-driven macro themed world should reward those fund managers with a sound process and good grasp of fundamental drivers of the asset classes they invest in.
So …. we are almost at the stage where bad news is no longer good news … and that is unequivocally good news for pension funds.