A subject attracting much media attention recently, is the question of ‘tapering’ and what effect it might have on investment markets, especially the stock market.
Tapering refers to the process by which the US Federal Reserve starts to reduce the level of quantitative easing. Quantitative easing is the process by which the Fed buys bonds and other assets from the private sector to inject cash into the economy. It has been one of the main weapons used to counteract the GFC and get the American and global economies back on track.
Currently the US Fed is buying up bonds at the rate of $85 billion a month. Any reduction in this rate would amount to a reduction in the level of quantitative easing. Any reduction will happen gradually and hence the use of the word ‘taper’.
By reading the press, you get the impression that the start of tapering will be a big deal and the inference is that it could be very bad for the sharemarket.
Academy
In order to get a deeper understanding of events of this kind, and to help separate the substance from the noise, I attend the Portfolio Construction Academy forum in Sydney several times a year. It is run by the Portfolio Construction group, which was established about 10 years ago by Graham Rich. Graham has for a long time been one of the pacesetters in financial research in Australia. Prior to setting up the Portfolio Construction group, he established Morningstar in Australia.
These events attract leading independent thinkers and researchers from around the world.
The November meeting included a session devoted to the question of tapering – and what effect it would have on markets – led by Dr Robert Gay, who is now a consultant but in the past has worked for the US Federal Reserve. He was one of the staff who advised the board of the Federal Reserve on monetary policy and the direction of interest rates.
It was a very worthwhile meeting, and provided a number of insights into the whole question of tapering and what impact it might have.
Background
But first, some background:
- Despite what has been written about the US Federal Budget deficit, big steps have been taken to get it under control. Last year, the deficit was around $1 trillion. This year, it will be about $500 billion – or a reduction of 50%. A deficit of $500 billion is still too big, but it is a lot better than $1 trillion and it is heading in the right direction.
- The fall in the deficit amounts to withdrawing $500 billion from the US economy. Despite this, the economy has kept growing at the rate of 2-2.5% – not great, but respectable. If you factor back in the deficit reduction, the growth rate would be 3-3.5%, which would be very good. Early this year, there was a lot of press coverage to the effect that any budget reduction of this size would be very bad for the economy and probably cause it to crash. Clearly that has not been the case.
- American banks are very sound. They have rebuilt their balance sheets to put them in a strong position (unlike many of their European counterparts).
- Bernanke is due to end his term as Governor of the Federal Reserve in early 2014. His successor will be Janet Yellen, who has been vice chair. She is very much a continuation of the Bernanke approach and any big change is unlikely. Interestingly, at her nomination by President Obama, Yellen referred to the three goals of the Fed as:
a. Low inflation
b. Low unemployment
c. Stability of the financial system
Points (a) and (b) have been openly and regularly discussed by Fed Governors for decades. But, this is the first time that any Governor, or nominee for Governor has ever publicly acknowledged (c). It is probably a measure of the determination of central bankers to see that we do not get a repeat of the GFC, when the worldwide financial system came close to collapse.
Conclusions
So where does this leave us? For a start, it seems likely that the US Fed will start to taper early in 2014. There may well be some volatility at this time. However, unless tapering is done in a very heavy handed manner it seems unlikely that the markets will be adversely affected, except possibly in the very short term.
For Australia, the effect could well be positive. For ages now, the Reserve Bank has been trying to talk the Aussie dollar down. It has fallen since the middle of the year, from just above parity, to around the mid 90 cents for a while, and now to about 90 cents. Clearly the Reserve Bank would like to see it fall further (the Governor has said so on many occasions). Tapering would help this. A corollary of tapering in the USA is some increase in interest rates there. This would improve the attractiveness of the US dollar against the Aussie dollar. Any fall in the Aussie dollar would be a big boost to our economy. Our exporters will earn more in Aussie dollar terms for what they sell abroad and imports will become more expensive – thus providing some relief to businesses such as manufacturing and tourism, which have been competing against imports made cheap by a high Aussie dollar.
When tapering starts, there is sure to be plenty of press coverage and much of it will no doubt be of the doom and gloom variety. However, on current indications it seems there is little to worry about so far as the share market goes, and it could be positive for Australia.
One area that will suffer is the bond market and losses there are a definite possibility. One effect of higher medium and long-term rates is falling bond prices. We saw this in the early 1990s (with the worst in 1994) and the early 1970s (with the worst in 1974). You will notice that there was a 20-year gap between these two events and next year will be 20 years since the last time. It may all be coincidence or there could be a 20-year cycle at work – time will tell.