Notice: This newsletter is intended as a general financial market outlook, and should not be relied on as investment advice.
The decision in December 2013 by the US Federal Reserve (the Fed) to finally begin its long -awaited reduction in the U$85 billion of Treasury bonds and mortgage-backed securities it was buying each month (known as Quantitative Easing-QE) has had dramatic effects on world stock markets. The actual reduction was fairly small, with the Fed only reducing the amount of its purchases by U$10 billion (all figures U$) in December although it announced another $10 billion reduction at the end of January. This means it’s still buying $65 billion a month, or $780 billion in total over the next year, but the move was enough to send the emerging markets into turmoil, with the MSCI Emerging Markets Index experiencing its worst start to a year ever, down 8.7% so far, while numerous emerging market currencies such as the Indian rupee, Turkish lira and South African ran fell to all-time lows against the US dollar. The disruption in markets even caused the US stock market, as represented by the broad S&P 500 Index, to sell off by more than 5% over the last month and other developed markets have also been badly affected. In all, $2.9 trillion has been erased from the value of global stock markets, with tapering worries being reinforced by concerns over slowing Chinese growth.
Meanwhile, worries that the reduction of the support to the US government bond market from QE were proved unfounded, as the yield on the benchmark 10 year US Treasury bond fell to 2.6% at the beginning of February, its lowest for three months and before that since the rumors of imminent tapering first surfaced in May 2013. With factory orders in the US in January 2014 suffering their steepest fall for 33 years, with the ISM Index falling from 56.5 to 51.3 (anything below 50 is regarded as indicating a shrinking economy) and China’s Purchasing Managers’ Index (PMI) falling to its lowest level since May 2013, investors are concerned that economic growth in the two largest economies is stalling. Morgan Stanley has downgraded its forecast for Chinese GDP growth to 6.6% for the first half of 2014, and the export segment of the Chinese PMI has fallen below 50, indicating that demand from major Chinese trading partners such as the US and Europe is slackening.
This is not the most encouraging situation for the new head of the Fed, Janet Yellen, who became the first female chairman of the institution in its 100 year history on February 3rd. However, Ms. Yellen is regarded as being even more dovish than her predecessor, Ben Bernanke, as regards providing enough liquidity to prevent the US economy falling back into recession. It has been made clear that the Fed is looking at unemployment as a major factor to judge when policy needs to be tightened, and Mr. Bernanke explicitly stated that policy would not be tightened and interest rates would not be raised until unemployment had fallen to 6.5%. It may turn out that the sharp fall in the ISM Index merely reflects the appalling winter weather that has affected North America over the last two months, but if it does indicate deeper issues, the Fed may well hold off reducing tapering any further through the summer. Then mid- term Congressional elections come into view, making it unlikely that there will be any major moves until early 2015.
For the Chinese authorities, who are attempting to rein in a major credit boom that has led to property prices rising rapidly amid worries over the unofficial finance market that has been promising investors high returns while lending to insolvent state owned enterprises (SOEs), they are aware of the need to let the air out of the credit bubble gently. A trust company product that had lent to a bankrupt SOE was recently bailed out by one of the state controlled banks, although investors will only receive their principal back and have to agree to the terms within a tight deadline. The new Chinese leadership is conscious of the need to balance slower and more balanced GDP growth with social stability, which requires GDP continuing to grow at a reasonable pace.
What the sell-off has done is make the emerging markets look like very good value. After falling 5% in 2013, and another 8-9% so far this year, the MSCI Emerging Markets Index is now selling at 11 times 2013’s earnings and 8.9 times 2014’s forecast earnings, the lowest since 2007 and a 40% discount to the Price/Earnings ratio of the developed markets in the MSCI World Index, the widest gap since October 2008. Meanwhile, the increase in short term interest rates by such countries as Turkey and South Africa last week, after their currencies had weakened by more than 5% against the US dollar since the beginning of the year, has begun to have some effect. Both the Turkish lira and the South African rand have rebounded more than 1.5% in the last few days and the Russian ruble has also strengthened from a five year low against the dollar. The difference in bond yields between US Treasuries and the U$ denominated emerging market bond index has fallen slightly to 361 basis points (3.61%), giving it a yield of 6.21%. As opposed to the emerging markets stock index, the bond index is only down 0.9% so far in 2014. Investors looking beyond the immediate worries over short term economic growth might consider switching some of their developed market bonds weighting into the higher yielding emerging markets bond area, as some of these countries do not share the current account worries that have affected Turkey, Brazil and South Africa, and have better demographics, finances than many developed countries as well as equal or better credit ratings.
All figures from Bloomberg February 4th, 2014.