TeleTrade: Global Markets Grappling Tapering, Stagflation Risks

As the U.S. Federal Reserve (Fed) moves from just talking about tapering to actually reducing the stimulus, investors may wonder what this might mean for their portfolios.

Tapering involves the process of phasing out asset purchases, but not selling the existing securities from balance (which is associated with tightening).

This time around, the Fed has prepared investors well in order to minimize the negative impact on the markets and stretch the reaction out over a period of time, so it is not so deeply felt.

However, some negative shocks cannot be avoided. Many market observers have dubbed the shock that was felt in October as a “VaR shock” on the back of an unprecedented increase in short-term yields, supplemented with realised volatility that reached 3-6 sigma (standard deviations).

What is the current tapering plan?

The total volume of US treasuries and mortgage-backed securities (MBS) on the Fed’s balance sheet is estimated at about $7.7 trillion – which is an all-time high.

The asset structure has slightly changed, and this time the Fed owns a larger proportion of USTs (69% of the Fed’s assets compared to 59% in 2013-2014) with shorter maturities (7.5 years compared to 10.2 years in the last QE completion period).

The reduction of bond buying is likely to be gradual. Depending on the scenarios, the balance is likely to be about $8.5 trillion after the termination of bond purchases.

The Fed is expected to kick-off tapering this month, after the Federal Open Market Committee (FOMC) made the decision during the November 2-3 meeting and is said to reduce purchases by $10 billion a month for UST and $5 billion a month for MBS.

Thus, the Fed will totally exit from QE within about seven months or by May 2022.

The Fed has the flexibility to accelerate or slow down the tapering process. After the tapering is completed, the proceeds from the holdings will continue to be reinvested, increasing the balance sheet, but at a much slower pace.

What effect could this have on FX and bond markets?

Theoretically and intuitively, tapering should lead to higher interest rates. In practice, this is not always the case. During the previous similar period of 2013-2014, yields grew before the beginning of the tapering process, but then fell during the period of actual reductions.

We believe that this pricing model reflects the strength of the Fed’s signals, which aim to be predictable for market participants. This time it may be different, because the yield on the belly and long-end of the curve is lower than in the past.

Tapering is as much about signalling as it is about implementation, and with tapering signals the Fed will have the flexibility to raise rates sooner rather than later, which is more important than QE policy adjustments.

DM HY and GEM segments of the bond market could be at risk as some risk-based strategies might be rolled back on rise of short-term funding costs.

The US Dollar should trade stronger. Any number of tapering paces exceeding $15 billion will be considered aggressive, while anything less will be considered conservative.

We believe that the figure of $15 billion has already been included in the USD quotes. The Fed’s funds rate signals (on dot plot to be published in December) are also important: there is now a significant discrepancy between market expectations and the Fed’s projections.

None of the FOMC members expect a rate hike in 2022, but the market estimates a tightening of more than 50 bps next year.

The expected impact on the stock market is much more comprehensive

The $120 trillion question is why, despite repeated, crushing VaR shocks in bonds, is the stock market ignoring the turmoil? A possible explanation is the prospect of another strong earnings season and relatively low real rates, which continue to support the current high valuation environment.

On the other hand, under historical observations, the flattening of the UST yield curve may indicate a rising risk of economic recession and therefore price peaks in stocks.

The absolute slope range of the 2Y-10Y curve also matter. In fact, only levels approaching the inversion of the yield curve suggest a large negative asymmetry in stock returns.

For the time being, the slope is close to the low-normal configuration and under this proposition, stocks are still making positive gains.

The last “tapering” in 2013 actually coincided with a record year for the stock market, when the S&P 500 index gained by 30%. This annual return was not repeated over the following five years.

The issue is that at the end of the monetary easing cycle the stock market peaks by multiplies, and earnings growth slows down in the following periods.

For example, over the 2009-2013 period, the S&P 500 index grew by an average of 15.8% per year, whereas over the tapering and monetary tightening period of 2014-2018, growth no longer exceeded an average of 6.7% per year. The earnings growth fell from 19% to 9% per year.

Corporate profits deserve special attention. In fact, there are more than a few signs that for 2022, corporate profits may be overly inflated. Firstly, weaker economic growth and rising inflation will affect the profits in 2022.

Secondly, many market observers underline the belief that 2Q21 was the peak quarter in terms of QoQ and YoY changes.

If the estimates are correct and the “baseline effect” disappears compared to the previous year, this implies relatively lower earnings if compared to the current 2022 earnings estimates.

Thirdly and most importantly, actual EPS estimates for the S&P500 index for the 4Q22 are $207/share, and this level will exceed the historical trend of exponential growth by 6% p.a., which has been holding back since 1950 – one of the most significant deviations in history.

The only two periods with similar deviations were in 2008-2009 and during the dot.com bubble. Without economic acceleration, the EPS market will hardly meet such an ambitious earnings target.

Could rising oil prices push the global economy into stagflation and trigger a significant market correction?

The rise in oil prices is part of a wider commodity super cycle reality, with the recent rampant price rally in coal and natural gas futures. The catalyst for further oil price increases may well be outstripping demand relative to supply, which will lead to a rapid reduction in reserves against the background of unrestrained substitution of gas with oil.

In addition, the expected peak in oil demand in this decade due to the pressure of climate change is currently keeping long-term oil prices at a low level compared to the forecast.

The UN Climate Change Conference (COP26) failed to provide a clear “aggressive” decarbonisation path, which means the world will probably need more oil to meet demand growth in the 2020s.

At the same time, the oil market has already seen a shortage in crude oil in the OECD reserves as it tries to cope with the steady growth in demand.

Global oil demand has already exceeded 100 million barrels per day and will soon return to the levels reached before the COVID-19 pandemic, according to BP estimates.

Needless to say, any future clash of supply and demand in the oil market could be much more detrimental to the global economy. At the moment, inflationary pressure is fueling the rise in prices for diesel fuel and other fuels, while rising electricity costs are also increasing producer prices.

Conclusions

Inflation expectations are adaptive, so the conclusions are generalised to cater for an uncertain future. Coordinated monetary and fiscal policies are a way of generating inflation.

And now all this is combined with the ramp-up of the commodity super cycle, a negative supply shock due to the shortage of semiconductors, and the limited logistical capacity of the main means of transport, as well as the need to solve the problems of climate change, which in itself carries a pro-inflationary component.

If the energy crisis deepens, the world economy will slow down significantly, inflation might exceed forecasts, and monetary authorities will ramp up tightening.

In a nutshell, easy access to liquidity and its cost, as well as the sensitivity of investment portfolios to see a jump in volatility, may play a major role in keeping the current favourable investment environment constant.

Ilya Frolov, Head of Portfolio Management, TeleTrade

Disclaimer:

Analysis and opinions provided herein are intended solely for informational and educational purposes and don’t represent a recommendation or investment advice by TeleTrade.

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