InvestmentsSep 15 2021

Do clients need to care about a 'taper tantrum'?

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Do clients need to care about a 'taper tantrum'?

In 2013, global economies were in what, in hindsight, looks like a sweet spot, with growth accelerating and inflation benign, the political uncertainties and pandemic had yet to arrive to disturb the calm waters in which markets and clients gently floated. 

Then in May 2013, representatives of the US central bank, the Federal Reserve, spoke at a Congressional hearing and outlined plans to start the gradual unwinding, or tapering, of the bank’s asset purchase programme, known as quantitative easing. 

Tapering means a “controlled slowdown” in the pace and quantity of bond buying by central banks, according to Simon King, chief investment officer at wealth manager Vermeer Partners, so while new money would still be created and injected into the economy, this would be at a slower pace than previously. 

The aim is to reduce the pace of money growth as economies recover, in order to prevent economies overheating and inflation becoming out of control.

In 2013, the response of the market to the first mention of tapering was a pronounced sell-off in equities and bonds. 

The tapering of asset purchases may be viewed as the first step in a process of tightening the monetary conditions

Richard Champion, deputy chief investment officer at Canaccord Genuity Wealth Management says: "Central bankers around the world are attempting to pull off a neat trick; how to remove at least some of the gargantuan monetary stimulus they’ve provided since the onset of the Covid-19 pandemic (which was on top of an already enormous amount of liquidity they’d been supplying since the global financial crisis all the way back to 2008-09), but do so without spooking asset markets. In other words, how to ‘normalise’ interest rates and QE (whatever that might mean these days) and avoid the kind of ructions that occurred back in 2013 when the Fed was last trying to do this kind of thing. This comes at the same time we’re experiencing a much-discussed upwards spike in inflation, which complicates central bankers’ decision-making."

This is because much of the liquidity created by central banks via QE found its way into investment markets, boosting asset prices. 

In addition, the tapering of asset purchases may be viewed as the first step in a process of tightening the monetary conditions, culminating in higher interest rates, which would be expected to slow the  economic growth rate, hurting the prospects of many equities and also causing bond prices to fall.

But George Lagarias, chief economist at Mazars Private Client, says it is events later in 2013 that should matter far more for clients today.

He says: “In May 2013 what was in question was not really the central bank bond buying programmes there and then; it was more about the market worrying how central banks would respond to asset prices falling in future. In other words, if the market took a downward fall again, would they just let it happen and continue to taper, or would they respond?

"Later in 2013, the Fed reversed course a bit and asset prices rose again. That told the market the Fed would always intervene and, even if tapering does lead to a fall in asset prices in the very short-term, it doesn’t really matter, because central banks will enter the market and send asset prices back up again.”

The European Central Bank announced on September 9 a very moderate reduction in its asset purchases, while communication from the US Fed indicates that tapering is on its agenda in the near term.

Equities in Europe sold off sharply in the days prior to the ECB announcement, while the market responds swiftly to any hint of the US central bank’s timeline or intentions around tapering. 

Lagarias' view is that any sell-off is driven by sentiment, rather than an understanding of the reality of the situation. He says: “A sell-off driven by short-term sentiment is the definition of a buying opportunity.”

Communication conundrum

King takes a more jaundiced view of central bank actions and is more cautious than Lagarias on the direction of markets. 

He says: “The point of the ‘controlled slowdown’ is that part of the way it is controlled is that the central banks communicate what they are doing, so the market knows the plan, and knows how to react. The problem over the past few years, and it was particularly the case with the ECB, is that they are not being very clear in their communication, and they change afterwards what they said if they don’t like the market reaction.

"To a large extent, the ECB is only going back to two months ago. In many ways, the tantrum of 2013 worked, the Fed went back on its policy, just as, as a father, I can say tantrums do often work.

"The thing is, in this market, everyone knows there is too much liquidity and that most asset markets and asset prices are too high. But no one is brave enough to take a view now. The thing is, tapering has never really happened in history before, so we do not know what will happen.” 

He says the bond market “tends to be a bit less emotive” than the equity market and so may provide a better guide to the future, and he says bond prices have been a bit more stable over the past year, persistently pricing in lower inflation for the long term, while equities have reacted to events by gyrating between a range of different outcomes. 

Liquidity matters

King says the best course of action in such an unpredictable climate is to ensure portfolios have ample ability to sell if need be.

King, who has been a professional investor since the 1980s, says: “One worry I have is that a generation of investors in the markets today have only ever seen the ample levels of liquidity we have now, but the ability to transact now is actually incredible relative to history.”

Lagarias says the equity markets have benefited more from QE than bonds have, and so the likelihood is that any tapering of QE would hurt shares more than fixed income products. 

 

Anthony Rayner, who jointly runs a range of multi-asset funds at Premier Miton, says the biggest mistake a client could make with regard to tapering is to try to second guess the timing or consequences, but says liquidity will be the key.

He says: “The worst way to prepare for many risks is to pre-empt them. Taking it to an extreme, you simply wouldn’t get out of bed in the morning.

"For financial markets, as in many other areas, it’s not very helpful being correct about a risk, unless you know when it’s going to occur and the actual nature of the risk, which helps guide an understanding as to its impact. Financial markets have become very accustomed to easy money and it seems reasonable to expect another episode when markets worry about some withdrawal. 

"However, without knowing the context, for example whether it will be driven by inflation concerns, growth concerns or a fading of the Covid-19 crisis, or indeed the timing, it’s unwise to take too much action. This is especially so at the moment, with so many additional factors for central banks to take into account, such as the Delta variant, evolving lockdown responses, challenging supply chain issues and new but uncertain fiscal policy.”

He adds: “There are things that can be done. Principally, it’s about preparing, rather than acting. Working through the most probable scenarios and their likely impact on assets and, importantly, holding liquid assets so that once the timing and impact become clearer, action can be taken quickly, if necessary.” 

David Thorpe is special projects editor of FTAdviser