The effect on non-US markets was instantaneous: European markets dropped 2%, the Yen strengthened by 4%, the Nikkei dropped by 7%, and Asian and Emerging Markets also fell sharply. The EM debt indices declined 3.5%. Whilst the US, European and Japanese markets all recovered those short term setbacks, the Asian & EM markets remained in the doldrums for the remainder of the year, as did fixed income with EM debt down 14%.
Given the seriousness of the demonstrated reaction to the gradual reduction in the QE programme in mid 2013, what's the likelihood of this type of "taper tantrum" being repeated this year, or in 2015, as we move closer to the moment at which the Fed actually starts raising interest rates?
Ironically, of course, rates will start rising in a belated reaction to the strength of the economy (specifically the US economy). Normally, a stronger economy is supposed to be good news for stockmarkets since it means better earnings and cheaper market valuations, right?
Although the current Fed Chair, Janet Yellen, is often at pains to emphasize that her Fed prefers to err on the side of "lower for longer", to avoid the risk of de-railing renewed economic momentum, there is little doubt that the continuing US recovery will result in rates being raised at some point next year (even if the initial moves will be very minor given the current "zero to 0.25%" current range).
Although the economy will be deemed robust enough to bear the increased burden of higher rates, it will be the mere change of direction - from flat to rising rates - that will represent a seminal shift for markets and sentiment.
When it does happen, it is also likely that market will over-react. It always does.
A good piece in today's FTfm section highlights the way in which "unconstrained" bond funds are viewing this scenario. Unlike their traditional bond fund brethren, such funds are, by definition, "unconstrained" by such niceties as being fully invested, and "have been given licence to stray from traditional market benchmarks, and focus instead on making the best positive return they can from investing across the fixed income markets".
Such funds are keeping 60% of their portfolios in cash at present, "fearful that too many areas of the bond market [have] become overheated and too many trades [have] become crowded".
This is where the difficulty arises: is it fair to charge investors a fee for sitting on cash?
The fund manager would suggest that it is (although we'd obviously expect them to say that), on the basis that you are paying the manager to generate returns and/or protect your capital. As the FT notes: "inevitably it is a question of timing", as the manager uses the cash he has carefully hoarded to jump in when the imminence of monetary tightening starts to cause panic amongst bondholders, thereby causing a big sell-off in fixed income markets.
As we saw in 2013, when that happens, the knock-on effect to stock markets is potentially significant: typically the higher beta markets (Asia & EM) get hit hardest as investors run for the exits and head for safety (probably cash). We have seen many times before that buying at such moments can lead to substantial gains in subsequent months if one is brave enough to jump. The key thing is having enough cash in reserve at the time to take advantage of such dislocations.
But - how long are investors prepared to wait...? The JP Morgan unconstrained fund, which holds 60% of its assets in cash, is sitting in the bottom 20% of its peer group for returns so far this year.
Waiting for the feared crash is starting to get expensive.
Our experience has also shown that clients don't like sitting on cash for periods of longer than a few months - understandably.But when does the need to preserve capital offset the shorter term drive to maximise returns?
Our answer to that is that - like everyone else - we don't know. But at some point, it will make sense to take a view and lock in gains and raise cash in preparation for a short-term market sell-off. Just not yet....
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