The revelation that the level of quantitative easing may begin tapering off at the end of this year has caused markets to sell-off, but it is too easy to let fear drive you to sell.
After the rally in world equity markets this year, US Federal Reserve chairman Ben Bernanke brought investors back to reality with his plans for quantitative easing.
While there had already been talk of tapering, Bernanke surprised the market by revealing that it could begin at the end of 2013 if the economy improves in line with current projections. However, he stressed that any such action was data-dependent and “in no way predetermined”.
Despite highlighting that the Fed was ‘taking its foot of the accelerator and not hitting the brakes’, the markets reacted as if the vehicle had crashed! The FTSE 100 lost over 1 per cent, Japan’s Nikkei fell around 4 per cent and the S&P 500 fell 1.4 per cent.
We feel there has been somewhat of an overreaction to what is an inevitable event at some stage. This is particularly as the Fed made it very clear that any tightening of policy is conditional on economic data. The key drivers of this are unemployment and housing.
There is uncertainty on the horizon, as the Fed is looking for faster economic growth and a pickup in inflation. Inflation has fallen to less than 1 per cent, about half the Fed’s target rate. The government on Wednesday said the economy expanded at an annual rate of 1.8 per cent — well below its initial estimate of 2.4 per cent.
This allayed fears of quantitative easing being slowed too early and equity markets reacted positively to the news. These lower than expected growth numbers add impetus to Bernanke’s idea of variable QE, less if the economy does well and more if it sags.
The latest rally shows that if the positive trend in data stalls or reverses, markets will begin to price in a later date for tapering and eventual interest rate rises. This may counter-intuitively provide support to assets prices.
In reality, interest rate rises still seem to be a way off. The outgoing Bank of England governor Mervyn King said on Tuesday at his last hearing with the parliamentary Treasury committee that Bernanke “certainly wasn’t announcing the end of QE” and it’s premature to talk about raising interest rates.
The Bank of England itself is a long way from tightening monetary policy. Bank of England deputy governor Paul Tucker said that an interest rate hike in Britain was not imminent, as it would only occur once the British economy had reached “escape velocity”.
In the US, with mortgage rates jumping as benchmark interest rates have increased, it is possible that the Fed has threatened the sustainability of an economic recovery that is predicated on an improving housing market.
Bernanke said that the Fed is monitoring these rates, but expressed hope that consumer confidence could offset the increase. The Fed is not going to jeopardise the economic recovery of the US and so fears that tightening could happen too quickly look overdone.
With monetary easing in Japan ongoing at an unprecedented scale and a seemingly more dovish Mark Carney appointed at the Bank of England, it is not as if the loose policy rug has been pulled from underneath financial markets.
As the FTSE has moved through the earnings cycle in recent months, the forward price-to-earnings ratio has started to look more attractive and sensible. We have found some opportunities in for example some oil services stocks through our direct equity research.
Valuation looked so stretched in early May that we decided to add some hedges to portfolios through buying some covered call strategies. These dilute upside participation, but provide downside protection to market falls. Higher volatility delivers higher option premiums on the call options, but should volatility subside, attractive valuations may lead us to take off the protection and invest more in the equity markets.
However, we believe that investors should not be spooked off equities yet, as material changes are still a long way off.
John Dance is chief investment officer at Vertem Asset Management