Reversal of QE, rate hikes key catalysts global markets
KUCHING: The reversal of quantitative easing ( QE), rate hikes and rising inflation pressures in the US are among the most impactful factors for the movement of the global financial markets in 2018, an executive at Templeton Global Macro (Templeton) observed.
“As we look ahead in 2018, we expect the reversal of QE, rate hikes and rising inflation pressures in the US to be among the most impactful factors for global financial markets in the upcoming year,” Templeton executive vice president, portfolio manager and chief investment officer Dr Michael Hasenstab said in a statement released by Franklin Templeton Asset Management ( Malaysia) Sdn Bhd and Franklin Templeton GSC Asset Management Sdn Bhd.
“For nearly a decade, financial markets have surfed a wave of low- cost money in the US, courtesy of the US Federal Reserve’s (Fed’s) massive QE programmes that were launched after the global financial crisis (GFC) of 2007–2009.
“The expansion of the Fed’s balance sheet from around US$ 900 billion in 2008 to nearly US$ 4.5
As we look ahead in 2018, we expect the reversal of QE, rate hikes and rising inflation pressures in the US to be among the most impactful factors for global financial markets in the upcoming year.
trillion today has arguably been the most dominant force shaping global financial markets. “QE has driven down yields and pushed up asset prices, steering many investors toward riskier assets while keeping the costs of capital artificially suppressed. “This has distorted valuations in bonds and in equities. In short, the era of QE has created a seemingly complacent market that views persistently low yields as a permanent condition. “However, these conditions are neither normal nor permanent, in our assessment, and we expect the reversal of QE by the Fed to meaningfully impact financial markets in 2018 and beyond,” he said. He added, “When the first rounds of QE were initially deployed by the Fed nearly a decade ago, many skeptics argued that pumping money into the financial system would cause high inf la- tion.
“But inflation never accelerated, in part because banks and financial companies stockpiled cash while credit activity remained constrained by post- GFC regulations, such as the Dodd-Frank Act.
“However, the factors that previously limited inflation and money creation over the last decade are also now approaching their end.
“Deregulation efforts through executive action are already underway, while credit activity has been accelerating. In short, the credit expansion and money velocity that did not materialise over the last decade is just beginning to take shape.
“This potential acceleration in money velocity combined with existing inflation pressures in the US economy and labor markets leads us to expect higher inflation and higher UST yields in the upcoming year. We think investors need to consider preparing for these risks.”
Aside from that, he highlighted that there could be a number of factors poised to pressure US Treasury ( UST) yields higher, including the aforementioned reversal of QE as the Fed unwinds its balance sheet, but also the exceptional strength in US labor markets, rising wage and inflation pressures, ongoing resiliency in the US economy, and a structural shift toward deregulation by both the Trump administration and a Jerome Powell Fed.
“Investors who are not prepared for the shift from the recovery era of monetary accommodation to the expansionary post- QE era may be exposed to significant risks, in our view.
“Markets could see sharp corrections to UST yields in upcoming quarters, similar to the magnitude and speed of adjustments that occurred during the fourth quarter of 2016. We think it is critical not only to defend against current UST risks but to structure portfolios to potentially benefit as rates rise,” Hasenstab warned.
“The challenge for investors in 2018 will be that the traditional diversifying relationship between bonds and risk assets may not hold true in this new cycle of UST declines.
“It’s quite possible to see risk assets also decline as the ‘ riskfree’ rate (yield on USTs) ratchets higher. Markets have become accustomed to exceptionally low discount rates— a shift higher would materially impact how those valuations are calculated.
“Additionally, we’ve seen a sense of complacency develop across the asset classes as UST returns and risk asset returns have often had positive correlations, along with positive performance.
“However, the positive outcomes achieved under the benefit of extraordinary monetary accommodation can mask the actual underlying risks in those asset categories.
“As monetary accommodation unwinds, those positive correlations could continue but with the opposite effect— simultaneous declines across bonds, equities and global risk assets as we exit an unprecedented era of financial market distortions. These are the types of correlations and risks we are aiming to avoid in 2018,” he added.
On the impact of the Fed’s policy tightening, Hasenstab noted that the impact should vary from country to country in emerging markets.
Dr Michael Hasenstab, Templeton executive vice president, portfolio manager and chief investment officer