Business

The punch bowl is really going away

The Sterling Report

With Kevin Richards

Sunday, February 02, 2014    

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LAST Wednesday the Federal Open Market Committee (FOMC) met for their monthly deliberation on the direction of the US economy and what actions they should take to restore order to the financial markets and stimulate growth. With literally no surprise, the FOMC decided to step up their tapering efforts with a further reduction in their bond-buying spree down to $65 billion per month from $75 billion. This, in some circles, proved to be clear evidence that the recovery is on in earnest, and critical targets such as economic growth seem to be on track. By Thursday, reports surfaced that growth had crashed through the elusive three per cent mark in the fourth quarter, adding to the Fed's euphoria that it was time to really take away the punch bowl. Analysts still expect US growth to hold at about 2.8 per cent for 2014 and 3.2 per cent could prove to be a welcome surprise, despite a year of budget stand-offs and still relatively high unemployment. The true test of the effect of Quantitative Easing (QE) will come with the release of employment data this Friday (and in coming months), at which point memories of last December's disappointing jobs number will be a distant galaxy away.

The net effect of all this is that although the growth numbers have been slightly above estimate and inflation has been modest, equities continue to take a hammering, registering a 4.5 per cent decline since the start of 2014. You will recall that last week, in this column, issues were raised about the equity market's ability to repeat the stellar year it had in 2013. Ironically, the fearmongers have been dogging the bond market outlook based on the prospect of an aggressive Fed taper, ultimately leading to interest rates rising dramatically this year, which has only served to help bonds perform well. Their analysis is, however, flawed and contrary to everything that one may have learnt in business school — that is, of the inverse relationship between interest rates and stock prices. If the expectation is for interest rates to rise, why then would the average investor seek returns in the stock market? If the flow of liquidity from the Fed dries up, what would become of inflated asset prices in the stock market as evidenced by its relatively higher P/E ratios?

At some point treasury yields will continue to move in tandem with economic growth numbers, and if three per cent growth becomes more than a one-time thing this year, then it could be a safe bet that treasury yields could hover in the high twos to low threes for 2014. Of course, this assumes that all things remain as we expect them to and exogenous shocks do not thwart our outlook. It could easily be inferred that most of the effects of tapering have already been priced in into current treasury yields as evidenced by the above average level of volatility in the bond markets last year with 10-year treasury yield peaking at 3.03 per cent. For this reason alone, it is enough to believe that interest yields should not crash through 3.75 per cent per annum this year, again unless other events take place. Bonds still remain the comfort zone of many and the Great Rotation of the latter half of 2013, where billions of dollars fled bond funds and found a home in equity funds, may just come to an abrupt halt as yields rise. Fund managers will continue to manage their duration risk and move further along the credit spectrum to manage the volatility. In simple terms, bonds should perform better than expected this year and the simple fact that bonds pay interest and provide income, will be sufficient to keep volatility in check.

Speaking of volatility, the fear factor has been rising steadily in respect of emerging markets. China's cooling has become a bellwether of signs that the steam is running out of EM credits with growth is Latin America, for example, projected to be in the region of 2.4 per cent as opposed to the robust rates of four to five per cent in previous years. China has long said "ta-ta" to double-digit growth and struggles to stay above the seven per cent rate -- a problem most economies would love to have. It is important to note, because the continuing cooling of some the world's tigers does have implications for US aggregate demand and could serve to caution the Fed in how aggressive it tapers. Politics is also a factor that could drive how quickly the punch bowl disappears. 2014 is littered with a slew of mid-term elections and a romp to victory at the polls for the Republican Party could suggest a rejection of stimulus at the expense of a bloated Fed balance sheet. As we usually say, speak with a professional advisor before diving into financial markets, if not only for the preservation of your capital but also your sanity and blood pressure.

Kevin Richards is Vice President, Sales and Marketing at Sterling Asset Management Ltd. Sterling is a licensed securities dealer and provides investment management and advisory services to the corporate, individual and institutional investor. Feedback: If you wish to have Sterling address your investment questions in upcoming articles, please e-mail us at: info@sterlingasset.net.jm or visit our website at www.sterling.com.jm

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