Impact of QE3 tapering
This week, we at Bourse will be addressing some of the pertinent questions on investors’ minds regarding the issue of the imminent tapering of the third round of Quantitative Easing (QE3) by the Federal Reserve Bank (Fed).
There have been multiple QE efforts implemented by the Fed (Figure 1). The first round of quantitative easing (QE1) began in November 2008, where the Fed initiated purchases of up to US$500 billion in mortgage-backed securities (MBS). QE2 began in November 2010 when the Fed announced plans to buy US$600 billion in long term US Treasury bonds, in addition to the reinvestment of an additional US$250 billion to US$300 billion in Treasuries from earlier proceeds from MBS. On September 13th 2012 the Fed announced its third round of Quantitative Easing (QE3).
Under QE3, the Fed currently buys US$40 billion worth of agency MBS every month in an effort to improve the job market and reduce unemployment to 6.5 per cent. Furthermore, the Fed will continue to keep interest rates near zero until mid-2015 and maintain an accommodative monetary policy. Combined with its purchases of long-dated Treasuries under “Operation Twist”, QE3 entails the Fed buying a total of US$85 billion of assets a month. Unlike the previous programmes, QE3 does not have a defined time limit and will continue until decided by the Fed.
Impacts on Equity Markets
From the onset of QE1 in 2008, stock markets have fared better when comparing the 4 year annualised returns pre- and post- the advent of QE. Before QE, the World index was down 5.8 per cent as compared to being up 9.8 per cent post-QE. QE also had a positive impact on Emerging Markets, which advanced considerably (16.8 per cent) versus the returns pre-QE (1.1 per cent).
Implications of Tapering
With US Q2 GDP coming in at 2.5 per cent and the unemployment rate decreasing to 7.4 per cent in July 2013, there is heightened speculation that QE tapering will begin this year, with a potential end by May 2014. With the Fed Chairman Ben Bernanke having indicated his intention to start slowing asset purchases in September, emerging economies have been experiencing capital outflows, as investors consider the implications of QE3’s end. The outflows from emerging markets have had an adverse effect on the currencies, as well as bond and equity markets of many emerging economies.
US Treasury yields have been on the rise, pushing up yields on almost all assets using these benchmark securities as a pricing point. Consequently, USD-denominated developed and developing market fixed income assets have declined in price. This was represented by the Bloomberg USD Emerging Market Corporate Bond Index declining 7.2 per cent to 128.93 from a peak of 138.939 in early May 2013.
With QE depressing US Dollar interest rates, the US dollar depreciated against other currencies. As the Fed prepares to slow and eventually end its accommodative policies, the US dollar should strengthen further against other currencies. The currencies which would be most impacted include nations which would have benefited from an influx of investor funds supplied by the numerous QE programmes.
Using India as an example, we note that the Rupee would have depreciated approximately 16 per cent versus the dollar between June-August 2013. The Indian Equity Index (Sensex) would have declined 6.8 per cent over the same period. While these may not be encouraging signs to some investors, a closer look at India’s net equity flows provide evidence as to continued investor confidence in the market.
In spite of market volatility and heightened uncertainty throughout the year, net equity inflows remained positive through January- May 2013. While India experienced net equity outflows during June-August 2013, the magnitude of outflows were small in comparison to fund inflows which would have occurred in the trailing 12 month-period (Exhibit 2). This would suggest that, although some investors have been ‘rushing to the exit’ in India and other emerging market investment destinations, the longer-term, patient investor has remained invested.
Notwithstanding the less-than-inspiring year to date market performance of Emerging Market nations, these economies remain the main drivers of global growth based on IMF’s projected GDP figures. China’s economy, which reported a Q2 GDP of 7.5 per cent, is showing good signs of stabilization and improvement in global demand. This will be positive for emerging markets, as China remains a major hub for world trade. The IMF projects a 2013 GDP growth of 6.9 per cent for Developing Asia and 5 per cent for Emerging Markets.
As the QE ‘dust’ begins to settle, markets should begin to normalise, with the embedded strengths of these emerging markets being the driver of investor interest. The developing economies all exhibit robust domestic demand, which has allowed them to recover from market turbulence more quickly than developed markets and grow at a much faster rate.
For India, Deutsche Bank and Goldman Sachs both anticipate that the BSE Sensex (major stock exchange in India) will provide a return of 14.3 per cent upside from current levels in local currency rupee terms. Together with the anticipated Rupee appreciation, using the average expectation of Bloomberg analysts, this would represent an expected USD equivalent return of 29 per cent for India over the next 12-18 months.
The recent correction in the markets have also made these emerging economies very attractive, when looking at forward price to earning valuations compared to the 5 year averages (Exhibit 3). This represents a very attractive entry point to all investors, as there exists great potential for higher returns from these markets in the medium to long term.
For more information, investors can call Bourse at 628-9100 or visit us at any one of our offices. Further information is also available on Bourse’s website at www.bourseinvestment.com and Bourse Securities Limited Facebook page.