There is no question about it, last week's US high frequency economic releases tilted heavily to the positive side. The NFP biggie came in ahead of expectations, as well as a whole host of other numbers.
Not surprisingly, the Treasury yield curve has steepened accordingly. The graph below shows the difference between the 2s and the 10s, which bottomed out in 2012 and has been steepening for most of this year.
An equity friendly environment
These developments that point to an improving economy should be equity friendly. Ed Yardeni encouragingly pointed to his analysis showing how changes in Manufacturing PMI tend to lead aggregate revenues for equities. While he expressed some doubts over the recent M-MPI spike, he did allow in later posts (see here and here) that a growth acceleration was real.
The indication that we may see a near-term upside surprise in revenue growth is especially positive, because I had been concerned about the upcoming Q4 Earnings Season that begins in January. Thomson-Reuters recently deconstructed Street earnings forecasts and, as the chart below shows, consensus 4Q EPS growth depended mainly on share buybacks and "other", which is mainly margin expansion, but little or no revenue growth.
If we do see an upside surprise in revenues, then stock prices could soar because of better than expected Q4 EPS.
How does the Fed react?
These signs of a growth acceleration beg the BIG QUESTION. How does the Fed react in the face of thes signs of growth acceleration?
No doubt, tapering will be on the table at the December FOMC meeting (though Fed watcher Tim Duy thinks that a December taper is premature). Regardless, the question of a taper is only a question of when, not if. However, Ben Bernanke, Fed governors and regional Fed Presidents have mostly been emphasizing the message that "tapering is not tightening", especially when the markets freaked out during the Fed's May-September bout of "taperitis".
My base case is that when the Fed does taper, it will manage guidance in such a way to underline the message that "tapering is not tightening". Though there seems to be some controversy over the practice, but the most likely course of action is a policy to lower the unemployment threshold before tightening, as outlined by this Jon Hilsenrath article:
One idea under discussion is to lower that unemployment threshold from 6.5%, which could mean keeping rates down longer. Fed staff research suggests the economy and job market might grow faster, without much additional risk of inflation, if the Fed promised to keep rates near zero until the unemployment rate gets as low as 5.5%. Goldman Sachs economists predict the Fed will lower the threshold to 6% as early as December and reduce the bond-buying program at the same time.
Even though the news of an improving American economy appears to be equity bullish, here are the two bearish tripwires that I am watching for when the Fed begins to taper:
- Does the Fed give the market some sugary syrup to help the tapering medicine go down? (See discussion above about the unemployment threshold).
- How do emerging market bonds and currencies react?
The second consideration is especially important as the last round of "taperitis" almost sparked an emerging market currency crisis as the prospect of QE withdrawal pushed up global risk premiums (see It's the risk premium, stupid!). The chart below of the relative performance of the iShares JPMorgan USD Emerging Markets Bond Fund (EMB) against the SPDR Barclays High Yield Bond Fund (JNK), i.e. junk vs. junk, indicates that EM bonds have not really recovered from that episode and could be at risk should the markets react and push global risk premiums higher.
I am therefore carefully watching the EMB/HYG pair, as well as the performance of the Wisdom Tree Dreyfus Emerging Currency Fund (CEW), which is the EM currency ETF, for signs of global contagion from a Fed taper.
Indeed, JP Morgan analysts highlighted Brazil and Indonesia as the most vulnerable economies once the Fed begins to taper:
The mere mention of Federal Reserve tapering can pressure various emerging markets currencies, but two could be especially vulnerable when the Fed finally does pare its bond-buying efforts.
The Indonesian rupiah, already this year’s worst-performing emerging markets currency, and the Brazilian real are J.P. Morgan’s picks among developing world currencies that are vulnerable to Fed tapering.
“The risk is [even] higher for expensive currencies. Both BRL and IDR are overvalued versus their 10 year average REER,” Barron’s reported, citing the bank.
The EM Apocalyptic scenario
The EM elephant in the room is China. A Fed taper has the potential to topple China into a global financial crisis that drags down the global economy.
Here's why. Consider that the RMB is pegged to the USD and it has been appreciating slowly against the dollar. Also consider the fact that Chinese government 10-year paper is yielding around 4.5% while US Treasury 10-year is about 2.9%.
What would a trader do under these circumstances? Supposing you saw paper denominated in a currency pegged to the USD (but steadily appreciating) which has a yield significantly higher thanTreasury yields. Isn't that an open invitation to a carry trade?
Fortunately for the world, the RMB is not a freely convertible currency. Otherwise we would see every hedge fund piling into that trade and levering their exposure up 10 or 20 times and creating incredible global systemic risk. The main participants who are getting into that trade right now are Chinese companies that export and manipulate transfer pricing between their onshore (Chinese) entities and their offshore subsidiaries. Nevertheless, the exposure could be considerable and a Fed taper would be a signal to start the unwind of this carry trade. When the markets start to unwind a carry trade that is highly levered, the results are never pretty.
While I am not forecasting that such a catastrophe will happen, I am allowing for that possibility and watching market developments carefully.
Equity bull or bear?
Viewed in isolation, rising corporate revenues and a steepening yield curve in response to an improving economy are equity bullish factors. Investors, however, have to realize that they live in a global economy and they need to watch for the global effects of Fed actions.
Will the Fed be successful in convincing the markets that "tapering isn't tightening"? Does "not tightening" mean that risk premiums will rise, or will they remain compressed at current levels?
My best guess right now is that the Fed will be moderately successful in its messaging and US stock prices will continue to grind higher into 2014. However, I am acutely aware of the risks involved and therefore watching the Fed's actions carefully as well as how EM bonds and currencies react.
In a future post: I will discuss the fly in the ointment to the growth scenario.
Disclosure: Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”
None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.