By Gerry Fowler
We are now very familiar with the remarkable economic gamble which began in November 2008, when the US Federal Reserve began to buy up assets at a rate of $85bn per month. QE seems to have been with us forever but recent Fed rhetoric implies we are far closer to the end it than markets had been pricing even just a few months ago.
In fact, whatever specific tactics are undertaken to unwind, we are passing the point of peak liquidity, where the money tap that has allowed investors a low-risk ride on some high-risk assets will not be opened further. The tap, sooner rather than later, is going to be slowly turned off.
While the point at which liquidity returns to normal is probably at least two years away, markets are already beginning to price it in.
A “normal” market environment would see 10-yr yields of 4% based on assumptions about growth and inflation. Forward US swap data suggests that this is now likely in three years. Only six months ago the same measure implied that a return to normality was more than 10 years away, far beyond the investment horizon of most.
This watershed has enormous implications. In recent years, with no sign of a clear liquidity horizon, investors were encouraged to chase yields. They did so by buying the assets central banks were bidding for, such as MBS, or by targeting what appeared to be the highest returns, such as emerging market bonds and equities, where liquidity risk premiums were larger.
As the excess liquidity evaporates markets price in that evaporation, there will be a profound impact on the price and volatility of those assets most distorted by excess liquidity.
We do not expect a mere binary switch of bonds into equities but think there will be a more nuanced rotation from long duration, low liquidity, low quality and low yielding assets of any asset class. According to McKinsey Global Institute, the stock of global financial assets totals $175-225 trillion dollars (depending on whether loans are included). The beginning of a major reallocation of this stock of investments has the potential to dwarf central banks $2 trillion per annum best efforts to manipulate the flow in financial assets.
The implication of the flight to quality suggests that government securities in the US and Europe may not suffer a great deal more than they have; and investment grade bonds may remain in demand, without making new highs. High yield bonds and particularly emerging market bonds may not do so well where investors increasingly see this as a “sell on rallies” market.
Overall, we think the shorter liquidity horizon will have less impact on developed market equities than many other investments because they were less distorted by excess liquidity in the first place. This explains the recent relative strength and low volatility of US equities in particular through great turbulence in bonds markets. We also envisage greater demand for Japanese exposure as the key “quality improver” region.
There will no doubt be clarifications from the Fed, and other central banks, as they attempt to manage communications around tapering after the reaction when Mr Bernanke first alluded to it. But, like apparently distant objects in a rear-view mirror, the liquidity horizon is likely to stay much closer than investors thought until recently.
Gerry Fowler, global head of equity and derivative strategy at BNP Paribas.
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