Taper Tantrum II?
16 September 2016
The past week continued the pattern that had started in the previous week, consolidation of both bond and equity markets following the step up of both over the summer. The reasons given by market sources differ between the 2 asset classes. The fall in bond valuations due to the rebound in longer maturity yields is blamed on the ECB's omission to reassure that they will continue to purchase Eurozone government bonds (QE) beyond the current ending date of March 2017. Additional concerns that the US central bank may unexpectedly raise rates in September rather than December have, however, receded. Equity markets on the other hand are suffering from a combination of a lack of further economic growth surprises and a slight hangover from the summer rally.
While I am relieved that markets have entered a consolidation phase of their summer gains, the parallel downward movement of bond and equity valuations unnervingly reminds of the 2013 Taper Tantrum. That 2013 market upset, when both equity and bond markets corrected downwards markedly, was caused by the US central bank's then chair Ben Bernanke indicating that their QE purchase program was likely to come to an end over the course of the year. Similar to this year it followed a period of strong market returns at the beginning of 2013. This is how far the similarities go. Europe and Japan are suffering from such stubborn low-flation and low levels of business investment that I believe it very unlikely that they will indeed be able to suspend their QE purchasing programs early next year. On equities, there may be a decline in the '˜good-news' flow of the recent months, but the improvements in employment and wage growth across industrialised nations, as well as the improvement in economic outlook for both China and many countries of the emerging world bodes well for corporates and their earnings prospects.
Even the UK, which over the summer had turned into the '˜sick man' of Europe through the Brexit referendum shock, left the negative headlines last week. The Bank of England's governor Mark Carney reported after the monthly rate setting committee meeting that the rebounding activity levels in August had made a further rate cut or any other monetary measures unnecessary - for the time being. Markets took this news neither negatively nor positively, while the majority of commentators warned that this should not be misinterpreted as an all-clear for any negative effects of the UK's decision to leave the EU.
As stated before, at Tatton we are looking relatively more optimistic into the future than we did a few months ago. The absence of the feared Brexit shock waves and the resilience of the returning global economic growth dynamic gives us hope that investments will continue to have a positive outlook. There is certainly potential for market volatility as general confidence levels are low(ish) and more deeply divided between the '˜bulls' and the '˜bears' than they have been for a long time, but the general direction is pointing upwards.
Our focus therefore remains the risks to fixed interest bond valuations, which are still very overvalued and therefore with a risk of a brisk correction, once central banks hint at an end date for their QE programs. This time has not yet come, but in order to further our readers' understanding of the dynamics at play we have included an insight article into bond pricing at the end of this week's edition. I recommend this article to all those who have wondered why inflation linked bonds have done so much better than conventional bonds over recent years and/or tried to get their head around under what circumstances this might continue going forward. Structured CPD time should be recordable for this as well.
I will only give away this much here: Rising inflation expectations are not a sufficient condition for inflation linked bonds to become the saviours of bond investors, when the direction of general yield levels reverses and they finally rise again.