Although I expect 2014 to be a fruitful year for those investors pursuing a properly diversified approach to asset allocation (and particularly those investors subject to PMW’s guidance) it is likely that volatility in both sentiment and asset prices will be the dominant theme this year.
2014 is likely to be the year that the US economy will gain some real traction in respect of acceleration of economic growth. This is generally positive news but the short-term consequences are less so because if the patient is recovering it must now be weaned off the powerful medicine that has undoubtedly precipitated such recovery.
I am, of course, referring to quantitative easing (QE3 to be precise), which is the practice of printing money in order to buy assets (primarily government and corporate bonds) and hence transmit money to the financial system by influencing asset prices and market interest rates.
Until recently, the US Federal Reserve was printing money at the rate of $85 billion per month. To date around $3 trillion has been channelled into the financial system. Although the (US) domestic economy has been the primary beneficiary, it is evident that a good proportion of this money washed through the global financial system like a soothing balm.
In May last year Ben Bernanke, Chairman of the US Federal Reserve, hinted that a reduction in the level of asset purchases (Taper) was under consideration. Financial markets reacted with sufficient negativity (see Essence July/August 2013 for my article Cold Turkey) to persuade ‘the Fed’ to delay action.
However, times are changing. In December the US Federal Reserve voted to reduce asset purchases by $10 billion per month and at the end of January this year, a reduction of a further $10 billion per month was decided, bringing the monthly rate of purchase down to $65 billion. This has thrown global financial markets into somewhat of a panic although the reaction is perhaps overblown as it appears to suggest that this aggressive rate of Taper will continue.
It is significant that the January meeting was the last such meeting chaired by Ben Bernanke, who has now stepped down after 8 years and is replaced by Janet Yellen. Bernanke was the architect of quantitative easing in the US and I suspect that he wanted history to show that an end to what is a controversial policy was under way at the time of his departure. Yellen might well want to restrain the pace of Taper.
Quantitative easing is controversial because by printing more dollars, the US Federal Reserve is effectively diluting the value of existing dollars, which is not very popular with those that hold them. US investors have therefore been active in moving their money elsewhere in the world in order to mitigate the impact of currency weakness. However, now that Taper is evidently underway, US investors are expecting the US dollar to rise and are therefore in a hurry to repatriate their money before it does.
In other words, the soothing balm has not only stopped flowing, it is being sucked out of the places that it previously lubricated. This goes a long way to explain the recent pressure on currencies in the developing world, which had previously been supported by the inflow of US money. For example, during January 2014 alone, the Argentine peso has fallen by almost 20% against the US dollar. The Brazilian real, Turkish lira and South African rand are also down by between 5% and 10%.
I believe it was Warren Buffett who said “When the tide goes out you realise who was swimming naked”. It is true that much of the investor appetite for emerging economies was indiscriminate and therefore served to flatter the underlying economic situation in some countries. This also acted to slow down the impetus for structural reform. Nevertheless, it should be remembered that the income and wealth of emerging economies has grown substantially over the last decade and now accounts for almost 40% of global GDP.
Those countries that do face real pressure on their currencies have two primary methods of supporting the exchange rate. The first is to use foreign currency reserves to buy the domestic currency, hoping that this will drive up the value. This is a dangerous game to play and most central banks/governments eventually lose as they cannot compete with the weight of money in financial markets. The second is to raise domestic interest rates in order to encourage money to remain invested in the domestic currency. This is the favoured approach and, for example, the central bank of Turkey recently increased interest rates from 4.5% to 10% overnight.
It should be noted that US quantitative easing will have benefited other developed economies as well as developing economies. Policymakers will therefore need to be on their guard as future decisions on Taper will be driven by what is needed by the US economy and little attention is likely to be given to the needs of the rest of the world.
I haven’t had time to mention the risk of Eurozone deflation, or uncertainty about the effect of forthcoming tax increases in Japan. Needless to say, it will probably pay to take professional advice about how you should be investing your money to achieve the best return possible whilst respecting your tolerance of risk. Please contact me if you would like some help with this.