THE END OF EASY MONEY
NOW WHAT?
As the Fed draws closer to ending its monetary easing, investors must prepare to adapt to the post-liquidity world
Investors don’t like to be reminded that easy money doesn’t last forever.
U.S. Federal Reserve chairman Ben Bernanke hinted as much earlier this month, and investors responded by dumping their stocks, stopping a five-month rally dead in its tracks.
It was hard not to have a sudden sense of déjà vu watching it unfold. After all, back in March 2010 when the Fed announced it was ending its initial quantitative easing program, the Dow Jones Industrial Average fell 14% over the next three months. That led to more easing, dubbed QE2, which was pulled back in June 2011. Again, the Dow tumbled, losing 17% from April to October in that year.
It’s clear investors have become dependent on easy money. But for the first time in years, an exit from that paradigm is becoming very real. Although the Bank of
Japan and the European Central Bank will likely be easing well into the “foreseeable future,” as ECB president Mario Draghi said this week, an exit by the Fed will begin an inevitable countdown until the other central banks turn off their taps as well.
When that happens, investors will have to adapt to a post-liquidity world.
“The opiate of investors has been central bank liquidity,” said Michael Hartnett, chief investment strategist at Bank of America Merrill Lynch. “We believe liquidity withdrawal will not be painless and will create higher volatility.”
At present, the U.S. Fed is buying roughly US$85-billion a month in assets to help prop up the American economy. But that number hides how much liquidity the Fed’s easing, combined with loose monetary policies around the world, has pumped into financial markets.
Mr. Hartnett points out that the five biggest central banks have made US$12-trillion in asset purchases since the financial crisis began. Combine that with about 520 individual central bank rate cuts since 2007, most to near zero, and you have roughly US$33-trillion in fiscal and monetary stimulus spending during that time — to put that into perspective, that’s 46% of the world economy.
All of that has made borrowing easy and money downright cheap, allowing many stock markets to hit new highs this year.
The Fed will be the first to try to wean investors off their addiction to cheap cash. The process has already been painful and it hasn’t even begun yet.
“Investors will face increased and more diverse risks, making for higher volatility,” said Peter Fisher, senior director at BlackRock Investment Institute. “New risks are an emerging market funding crunch, a spike in real yields for the wrong reason [deflation] and an unhappy ending to Japan’s reflation experiment [volatile and rising bond yields].”
Mr. Fisher and his team at BlackRock outlined a handful of scenarios they expect to unfold in the financial markets this year, and assigned each a probability. The most likely scenario, with a 40% chance of occurrence, is what they term the “Age of Separatism.”
This scenario — increasingly talked about as the Fed draws closer to ending its easing — essentially involves a divergence from the economic and financial market correlation seen in the past few years. Since the financial crisis, stock markets around the world, as well as other asset groups, have increasingly moved in lockstep, often following headlines.
But that correlation could end if the Fed’s largesse winds down in September, as many economists are currently forecasting, even as the Bank of Japan and the ECB continue their
own easing policies. As a result, there will be an “increasing divergence between economic growth, policy moves and financial market returns,” Mr. Fisher said.
In this environment, Mr. Fisher and his team see stocks performing better than bonds, with many bonds looking “expensive and risky.” The opportunity, he said, lies in moving away from defensive and income stocks — which investors have recently favoured — to cyclical assets geared toward growth. He points out the valuation gap between high-quality and low-quality stocks are near record levels.
Of course, investors have to pay
Investors will face increased and more diverse risks, making for higher volatility
attention to more than just the end of the Fed’s cheap money. China made headlines recently as its overnight interbank rate spiked to 13.5% last week, well above the 4.3% average in the previous five months. Market analysts speculate the spike is an attempt by the Chinese central bank to tighten the country’s easy money environment, as well as a way to discipline Chinese banks for highrisk lending.
Many economists, however, praised China for the move, while also warning the beginning of its stricter lending practices could add to global liquidity headaches.
“The process of unwinding the credit surge of recent years will take time and will likely lead to periods of financial volatility, given that China’s financial system has not only grown in size, but also in complexity,” said Martin Schwerdtfeger, senior economist at TD Economics. He added that the tightened credit may also mean China’s economy is growing less than the 7.6% TD currently forecasts.
That’s an unnerving prospect, con--
sidering China’s insatiable demand for resources has been an important component of global growth in the past few years. Essentially, China is faced with the same problem as the U.S.: How to scale back liquidity without imploding the economy that the liquidity originally helped prop up.
But Bank of America Merrill Lynch’s Mr. Hartnett said a lot of those fears are already priced into stocks with the recent pullback in June. In his view, despite the daunting challenges investors face in a post-liquidity world, those willing to adapt will have plenty of opportunities to do so.
“Watchful of bond risks, we remain equity bulls,” he said. “We would look for opportunities in the five areas of value in the equity market: developed market banks, the Eurozone, Japan, China and BRIC resources.”
It’s no surprise that two of the first three recommendations are in regions where easy money will continue to flow after the Fed shuts off its tap and it is likely that those regions will continue to be favoured by investors in the coming years. But as credit tightens in the latter two, fear will cause investors to pile out of certain assets and reveal opportunities in the aftermath.
“This argues for near-term contrarian trading rallies in China and BRIC resources, as these are among the most out-of-favor and inexpensive areas of the market,” Mr. Hartnett said.
But such opportunities come with heightened levels of uncertainty. BlackRock’s team said its secondmost likely scenario this year, with a 25% probability, is a return to the risk-on, risk-off madness that defined markets in 2011 and 2012.
Whether that kind of roller-coaster trading returns this year or not, Mr. Fisher warns that fears of easy money coming to an end is likely to result in an unpredictable second half of the year.
“Investors got a taste of [volatility] in June,” he said. “And we believe there is more to come.”