What are the consequences of Federal Reserve tapering? 

 

The world of Cassandras is one in which doom and gloom is at every corner for decades on end, when the reality is far more complex. We most likely still have a few months of a market rally ahead of us, but the second half of next year might be difficult.

Heavy fiscal stimulus and ultra-easy monetary policy since the Great Financial Crisis have helped the global economy to recover but left it saddled with a mountain of government and corporate debt as well as high leverage. Financial assets rather than goods & services and the labor market have been the main beneficiaries. Parts of the financial market now expect a future that is unlikely to pan-out. Some parts of the equity market (such as Growth investors) are likely too optimistic on the aggregate and the US Treasury and European Government bond market far too pessimistic – though in the latter case negative interest rates have much to do with it.

When tremendous liquidity increases the demand for financial assets, it meets a supply that can be quite inelastic – and the result is a surge in prices. There is a limited amount of stocks and some markets (from mining to shipping and real estate) take a long-time to increase in response to higher demand. However, such liquidity pressure is either transitory or permanent. If stocks do not deliver higher earnings, valuation has to adjust as better opportunities lie elsewhere for excess liquidity. That was the example in the poor performance of value stocks (somewhat cyclical in nature) for a long time. Hence, liquidity sloshes around from one market to the next, concentrating on a few where the narrative of returns is credible such as Growth with leverage steadily building up and a giddy feeling spreading. The remaining liquidity finding no alternatives ends up in fixed income and credit at ever longer duration.

As liquidity is slowly withdrawn through tapering, the many channels of Quantitative Easing mildly reverse as we saw last week. In styles with high leverage and growth expectations, it can lead the market to greater hesitancy and that should amplify as interest rates rise making leverage more expensive and lenders more prudent. A rising cost of leverage should also shake the relative value industry where extreme leverage is used to exploit moderate opportunities. The question then becomes whether styles can correct brutally on over-valuation and peak momentum or do they need fear of a recession to come in. The most probable timing for a recession is 2023, though it is unlikely. What we are left with for next year therefore is whether the leveraged fueled narrative of High Yield and Growth can be sustained.

What professional investors have learned from past corrections is that the next large scale correction in risky assets should be different. The US Treasury market is already positioned for such a bearish outcome for example. Removing Black Swan events such as climate catastrophes, war and fraud, we are maybe left with hubris. Megacap growth companies may misjudge demand and their own risk of being over taken by cheaper and more nimble players. The exercise in the coming months will therefore be to figure out how this market unravels and how to position for it. The odds are though that the real concern will be when short-term interest rates are expected to rise and that should happen in 2022, most likely in the second half.

 

What does it mean?

With Federal Reserve chairman Jerome Powell stating at the Jackson Hole meeting that it might be appropriate to taper this year though it signals nothing on the Fed fund rate, the process towards tapering is accelerating putting the September meeting well in play. One key concerns seems to be that they cannot take the spike in inflation to be temporary as granted which seems to be roughly what the market expected. Faced with the early phase of this process of tapering, we continue to prefer solutions such as equities focusing on ESG criteria, as this remains a secular force, and multi-asset solutions which offer flexibility and a diversification across styles.

World, Real Estate Prices, HPI, Current Prices, Index, Federal Reserve Bank of Dallas, Residencial, Price Index

Source: Nordea Investment Funds S.A. and Macrobond

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