News in Charts: Global Economic and Markets Outlook 2013 Q3

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The taper is on – can Europe decouple?

A central theme of our Global Economic and Markets Outlook for the past several years has been that the US economy would de-couple. How right we were. It has, and more comprehensively than we imagined it would. The explanation we have always given for that view is that the US has used the time afforded it by the Fed’s ultra-loose monetary policy including QE and asset purchases effectively, to deal with the aftermath of the financial crisis and in particular the recapitalisation of its banks. By doing so it created the room for a cyclical recovery to flourish. In our view, it is largely alone among the major central banks – and here we include the PBOC – in having done so. This was the primary reason we were heavily underweight US Treasuries.

However our confidence that the Fed would do all that it could to avoid a simultaneous tightening of both monetary and fiscal policy through 2013 appears misplaced. After the June FOMC meeting, Fed Chairman Bernanke indicated that it may be appropriate to slow down, or to ‘taper’ the rate at which it purchases assets before the end of this year. This statement took many, including ourselves, by surprise. Indeed, three months ago we felt that the Fed was likely to increase the degree of monetary stimulus before it began to withdraw it. That is why we believed the US would do well in the ugly currency race, with the dollar expected to fall against most currencies, and against the euro in particular. On that count we were proved wrong, not least because the ECB also surprised us by appearing to commit itself to keeping rates at or below their current level for an extended period. Bundesbank objections notwithstanding, the main news to our forecast is that the dollar has strengthened across the board, and notably against the euro. It is clear that both the ECB and the Bank of England – now under new management – are keen to distance their policy stance from a potentially less accommodative Fed; with, in our view, good reason. That is the background to our latest forecast.

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On our new central view, the US economy will take the jump up in yields seen in recent weeks squarely on the chin. Growth through this year and next will be weaker than we thought three months ago because policy will be tighter. But the process of tapering does not derail the recovery. We expect that process to take the form initially of a reduction in purchases of residential mortgage backed securities (RMBS) below the current rate of $40 billion per month, with these purchases falling quite quickly to zero. There are two reasons for this. First, the US housing market simply does not need this support any more. Second, by continuing to purchase US Treasuries at, or even a little ahead of the current $45 billion per month, the Fed can argue that it is maintaining the highly accommodative monetary policy that Bernanke said earlier this week is “appropriate for the foreseeable future”, while simultaneously beginning the tapering process. The Fed has been at great pains to reassure markets that the process of unwinding QE is entirely separate from an old fashioned policy tightening, in the form of a higher Fed Funds rate. On our central view, the Fed Funds rate remains close to zero for a number of years yet.

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The risk is that we are wrong – the US cannot take it, and instead slips back into recession, or at least slows by much more than we expect in our central case. Our model based on a set of monthly macro indicators assigns a probability to the occurrence of a US recession, and is already flashing amber. The chance of a US recession is now around one in five.

Moreover, were such a risk to crystallise, there is a significant danger that the withdrawal of liquidity support will impact all asset prices to such a degree that it could trigger a series of bank failures and defaults in those regions which have not used the time afforded to them by QE productively.

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Our asset allocation reflects the changed economic environment. Yields are set to remain volatile, but elevated. There is no turning back for the Fed now, at least not in the short-term. Our US bond market model suggests that, if the Fed follows the path set out by Bernanke after the June FOMC meeting, tapering this year, and stopping purchases next year before gradually unwinding its position, then yields could rise by a further 175 basis points, moving beyond 4.0%. And that is with no increase in the Fed Funds rate. That is why we are underweight government bonds, and US government bonds in particular. Emerging markets and commodities suffer. The impact on other asset classes is uncertain. If tapering is supported by a strengthening US economy, as in our central case, then equities should do well. That explains our equity overweight.

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