As Warren Buffett said: “Only when the tide goes out do you discover who has been swimming naked.”
So it is worth investors screening their portfolios to ensure they have not taken on unacceptable risk in the search for yield, and that the assets in their portfolios have sustainable amounts of leverage.
Some emerging economies, in particular, did take on too much leverage in the period of low interest rates and are now vulnerable to rising debt servicing costs.
Turkey and Argentina are prime examples, and their markets have accordingly come under pressure over the course of 2018.
While some nations in the emerging world may still be hurt by higher yields, it is important to remember that not all emerging markets are the same. Some of these nations learned the lessons of the taper tantrum in 2013 and have since reduced their external vulnerabilities.
In fact, many of the Asian economies have seen their current account balances improve and have reduced external debt, which means they should be much better prepared to cope with rising interest rates.
High price of bonds
For fixed income investors, it will be more challenging to find positive returns in the form of increasing bond prices due to falling yields, given that QT should lead to higher yields. It is therefore important to think in terms of total return, rather than just price return.
Within credit markets, investors will need to be particularly vigilant, as some pockets of the market, such as US investment grade, have seen a deterioration in their fundamentals. As it stands, almost 50 per cent of the US IG benchmark index is made up of bonds with the lowest credit rating that permitstheir inclusion.
With more investors now exposed to riskier credit markets as a result of QE and the search for yield, we need to think about whether we have taken on a much higher degree of liquidity risk.
The impact of QT on equity markets will depend on the extent to which corporate earnings increase alongside interest rates. A faltering economy is a more direct threat than the removal of monetary stimulus.
However, investors may wish to consider focusing on sectors and styles that are positively correlated with higher interest rates, such as the banking sector and the value style, and look to avoid those with more extended valuations, such as growth.
QT is not something to fear necessarily, but as central banks begin to take away the punch bowl, there should be an increasing focus on quality assets – those without unsustainable levels of leverage – across the asset class spectrum.
Vincent Juvyns is global market strategist at JPMorgan Asset Management