The so-called US Federal Reserve “taper tantrum,” fear of a credit crunch in China, and hot spots of unrest dotting the globe contributed to a sense of market panic that swept both stocks and bonds in June. One thing’s for certain, the calendar may have shifted to summer, but volatility hasn’t taken a vacation. As you might expect, contrarian investor Dr Michael Hasenstab (pictured), co-director of Franklin Templeton’s International Bond Department, says investors with cool enough heads to look past short-term market panics can find opportunities while those who can’t stand the heat may miss out…
Investors need to separate out long-term trend shifts from short-term market panics. It’s critical to understand or disentangle the recent volatility in fixed income markets. There were two major factors. One was the rise in interest rates, which, in our view (and what we’ve been positioning for), could likely be a permanent move higher. I consider this rise in rates from exceptionally and distortedly low levels in many countries as moving toward more normal levels. I don’t think we’re fully there yet in terms of an equilibrium level, but we’ve at least begun to adjust.
The other factor was just general risk-aversion, a bit of panic, contagion. That’s something that we’re always susceptible to for short periods of time. In our view, some of the recent fixed income losses due to interest rate exposure could be more permanent; however, we believe some of the recent factors causing declines due to market contagion and currency volatility may be more temporary.
There was probably a little position adjusting, particularly in some of the local emerging markets which in the short term were perhaps slightly overbought. Now that is being cleaned out. However, we feel the declines in emerging market currencies and some of the higher-yield spread sectors came on the panic that was tied to the typical reaction when, during a period of extreme market stress, regardless of fundamentals, all risk assets sell off. Since we believe those types of adjustments are due to temporary market contagion, we view this volatile period as a favourable buying opportunity that typically allows us to build positions at what we regard as attractive levels.
Major central bank policy turns are naturally going to cause some market dislocations. It’s pretty clear the Fed couldn’t continue printing money forever, and while some investors are panicking about what the end of the Fed’s easy money policy will mean, Fed tapering doesn’t equate to Fed tightening.
The end of Fed printing is inevitable as it is not a realistic expectation that the Fed could print money indefinitely, and frankly, the longer it went on the longer distortions in the market could have lasted. But it’s important to remember tapering does not necessarily mean tight policy. It means the end of an excessively loose policy. While there’s been talk of rising interest rates, it’s not likely to happen for quite some time, and, even then, it’s likely to be very moderate. So with the Fed eventually discontinuing its new purchases and even gradually raising rates, we believe that would still equate to fairly loose monetary policy at the margin given the size of the outstanding balance sheet. In terms of total policy, it would still provide a lot of liquidity to the rest of the world.
It’s important to remember tapering does not necessarily mean tight policy. It means the end of an excessively loose policy.
Additionally, the Fed indicated that any policy change would be a function of economic fundamentals, primarily regarding the strength of the US labor market. Given that inflation does not appear to be a near-term constraint, it’s unlikely the Fed would engage in tightening without some sort of economic improvement. In our view, an environment where the Fed is tightening because of improving economic fundamentals would be beneficial for the rest of the world, and particularly emerging markets. I think this fear of liquidity being pulled out of emerging markets due to the Fed ending its bond purchasing program is overstated as we do not believe there would be a massive contraction of liquidity out of emerging markets. Our view is that this is likely to be more of an entry point for investors as opposed to an exit.
Even when the Fed turns off the tap, other markets are still flooding the market with liquidity – namely Japan. Japan plays an important part of this total money creation exercise. The US has been pumping in approximately a trillion dollars a year through mortgages and Treasury purchases that will ultimately end. However, Japan is just about to start injecting about 10% of its GDP a year, which is a little more than a trillion US dollars a year. Thus as the US begins to taper, Japan is beginning to ramp up. In our view, it doesn’t really matter whether the Fed prints or Japan prints or Europe prints. If it’s printed, it’s going to flow out.
China’s central bank, the People’s Bank of China (PBOC), also made a market splash as it aimed to contain undisciplined lending in so-called “shadow banks,” which provide financing outside China’s state-run banks, with limited oversight. Liquidity was tightened in the interbank lending market in June, causing short-term interest rates there to dramatically spike from single-digit percentage levels into the double digits.
I think it’s important to understand what’s happening in China in the context of broader reform and the short-term need to rein in the shadow banking system. When a sector gets too hot, it is necessary to pull it back, and the People’s Bank of China has taken a tough line of action to discourage shadow banking activities and control the credit supply. For example, in the case of China’s real estate sector when prices in some of the big cities began to get out of control, fairly blunt instruments were used to correct prices fairly dramatically and fairly quickly. But I think this is the right decision. It’s better to resolve the problem before it gets too out of hand.
I think it’s important to understand what’s happening in China in the context of broader reform and the short-term need to rein in the shadow banking system. When a sector gets too hot, it is necessary to pull it back.
In the case of shadow banking, there was an explosion of credit in financial products, not necessarily into productive economic activity, and a lot was outside the control of the central authorities. They needed a way to send a message to try and regain control of this sector; squeezing liquidity was a very effective way of doing it. While all this has given China’s markets a jolt, Hasenstab doesn’t believe it will derail China’s entire growth model.
While their actions have created short-term pain, it is important to remember that these policy actions are reversible. We’ve already seen signs that there’s willingness to provide liquidity if the impact of these tightening measures begins to spiral into other parts of the financial sector.
Looking at the three different central banks (the US, Japan and China) that have rattled the markets this month, Hasenstab says fears of a global liquidity implosion are likely overblown.
Certainly there is going to be policy tightening, but I believe many countries are well-positioned to deal with less-abundant capital and in many cases, I think that will be a good thing. Too much capital can lead to bubbles, and it’s better to start to rein it in now.
