How to survive the Eurozone's taper caper

European Central Bank President Mario Draghi’s decision to extend the Eurozone’s Quantitative Easing programme by nine months to December 2017 but cut the amount pumped into the financial systems from €80 billion a month to €60 billion presents advisers and clients with a number of questions.

The experiences of the US’s move to taper its $85-billion-a-month QE scheme, first announced in May 2013 and implemented between the December of that year and October 2014, suggest markets could initially get very choppy.

All asset classes lurched sharply lower after the US first hinted at a tapering of QE

Source: Thomson Reuters Datastream. Results in sterling terms. Covers period 21 May to 24 June 2013.

Bonds felt the worst of the pain but equities also slipped and it took the MSCI All-World index a year to recapture the ground it initially lost (in sterling terms). Government, investment grade corporate and high-yield bonds eventually rallied too, albeit with the help of the launch of QE in Europe and increases to existing programmes in the UK and Japan.

Such assistance may be missing this time, as central banks seem minded to taper or even raise interest rates in the case of the US Federal Reserve.

The absence of price-insensitive buyers in the form of central banks could therefore present bonds with a fresh headwind, even after the sell-off suffered since the spring, which has accelerated since the election of Donald Trump as the forty-fifth President of the USA.

Central banks’ faith that they can afford to taper or tighten may also reinforce the prevailing narrative that the global economy is strengthening, with inflation likely to follow. Such a scenario has traditionally favoured equities over bonds and this again reflects recent market action, where equities have finally started to lead fixed-income assets. As pointed out by a brief comment from the shrewdies at Canada’s Otterwood Capital, this can be seen in the relative performance of Exchange-Traded Funds (ETFs) that track key benchmark indices on both sides of the Atlantic:

Stocks are finally leading bonds, using leading index-trackers as a benchmark

Source: Thomson Reuters Datastream, Otterwood Capital

Yet the very slow pace of US Federal Reserve rate rises (with only the second of this cycle due on Wednesday 14 December, a year after the first and two years after QE was tapered to zero), the ongoing QE schemes in the UK and Japan, the gradual tapering in the Eurozone and the marked absence of any commentary regarding the sterilisation and withdrawal of QE suggest the global economic outlook is more fragile than the current market consensus may have us believe.

In addition, the FTSE All-Share and FTSE 100 still trade below their spring 2015 peaks, Europe’s Stoxx 600 is a good 15% below its 2015 high and the headline US S&P 500 index is just 6% above where it was a year ago (even if it feels like it has done a lot better).

A few lingering doubts clearly remain and there can be no denying that the key long-term challenges of debt and demographics have not gone away.

It is good news that central banks do feel able to start tapering QE and tightening policy, as we would all like to see the cost of money normalise. But this will be the key test of whether the underlying economies are strong enough to stand on their own two feet or too weak to fend off a fresh downturn, or even deflation, without either monetary or fiscal stimulus to support them.

If the former proves to be the case, equities could make fresh gains and bonds fresh losses. If the latter scenario prevails, it is fixed-income which may resume its 30-year bull run and stocks that cede ground.

Taper tantrum

The past is by no means a guarantee for the future, as noted by Warren Buffett’s pithy remark that “If past history was all there was to the game, the richest people would be librarians.”

Nevertheless, lessons can be learned. It may therefore pay to look at what happened once the USA embarked upon its tapering of QE between spring 2013 and autumn 2014, as the ECB prepares to gently lower the amount of stimulus it is prepared to pump into the financial markets and the broader economy.

Then US Federal Reserve chairman Ben S. Bernanke first hinted at a tapering on 22 May 2013 in his bi-annual testimony to the Joint Economic Committee on Capitol Hill in Washington.

The result was the now infamous ‘Taper Tantrum’ as – to put none too fine a point on it – all hell broke loose.

Within a month global stock, bond and commodity prices had all dropped by between 6% and 12%, as shown in the very first graphic at the start of this piece.

Emerging stock markets were particularly hard hit, falling 17% in that first month against a 9% drop in the MSCI All-World benchmark. By region, the USA actually did best, falling 7% and Latin America the worst, down 21% in sterling terms. By equity sector Healthcare did the best on a global basis (or least worst), falling 8% in sterling terms.

This can all be seen in how the CBOE Volatility Index, or VIX, spiked immediately after Bernanke spoke, peaking at around 20.

The ‘Fear Index’ spiked when tapering was first mentioned in the USA

Source: Thomson Reuters Datastream, Otterwood Capital

Yet the same chart also shows how markets quickly adapted. Bernanke began the tapering of QE when he cut it from $85 billion to $65 billion a month in December 2013 and his successor of February 2014, Janet Yellen, finished off the job and stopped adding to QE in October 2014.

Although she had yet to sanction QE’s withdrawal and either the sale of the bonds the Fed bought or an end to the reinvestment of cash upon the maturity of any holdings, the VIX had receded to 12 by the time the taper was done, where it still stands today.

Over the period of the taper, stocks did best among the major asset classes and Government bonds the worst – the latter makes sense as the tapering of QE removed a major buyer from the scene.

Stocks beat bonds during the time of the US tapering

Source: Thomson Reuters Datastream. Results in sterling terms. Covers the period 21 May 2013 to 29 October 2014.

Developed markets handily outperformed emerging ones. By region, the USA did best in sterling terms, helped by dollar strength against the pound, while Western Europe held up relatively well, ironically due to hopes for a QE launch from the ECB.

It will therefore be interesting to see whether the euro regains some lost ground this time around, boosting returns from Eurozone assets for UK-based advisers and clients.

US equities did best during the taper

Source: Thomson Reuters Datastream. Results in sterling terms. Covers the period 21 May 2013 to 29 October 2014.

By sector, healthcare and technology did best, perhaps owing to their perceived relative immunity to the global economic cycle and strong long-term growth potential. They were however followed by the more cyclical areas in the form of industrials and consumer discretionary. Real estate lagged, perhaps hampered by concerns that tapering would lead to actual interest rate hikes (a view that was proven correct).

Healthcare and tech led the way during the US tapering

Source: Thomson Reuters Datastream. Results in sterling terms. Covers the period 21 May 2013 to 29 October 2014.

The case for tapering

It remains to be seen whether European stocks follow this pattern, following their show of resilience in the wake of the Italian referendum result.

The ejection from office of the pro-Europe Mario Renzi following his defeat had prompted fears in some quarters of a broad sell-off in European assets, but the worst-case scenario has yet to develop, even if the Euro Stoxx 600 is still really just flat-lining (although chart-watchers do argue the index is due to break-out …. one way or the other … from what they would assert is a ‘wedge’ pattern).

Euro Stoxx 600 is overdue a break-out move, according to chart watchers

Source: Thomson Reuters Datastream. Results in sterling terms. Covers the period 21 May 2013 to 29 October 2014.

At least it is encouraging that Mario Draghi and the ECB feel the Eurozone economy is strong enough to get by with a little less QE and therefore less monetary help.

Tuesday’s third-quarter figures show GDP growth came in at 1.7% year-on-year in Q3.

Eurozone GDP growth has been consistent, if uninspiring

Source: Eurostat, Thomson Reuters Datastream, Trading Economics

This compares to 1.8% for Q1 2015 when QE was first launched, so perhaps that offers a little less excitement than hoped. That said, unemployment is down to a six-year low and inflation is up to a 31-month high, even if the latter figure of 0.6% is still well below the ECB’s 2.0% target.

Forward-looking indicators such as the purchasing managers’ indices (PMIs) offer more comfort. November’s manufacturing score of 53.7 was the best since early 2014 and the services reading of 53.8 was the best in a year.

Advisers and clients should also keep an eye on Belgian industrial confidence indicator the Courbe Synthétique, as it has been an uncannily useful guide to the fortunes of the Euro Stoxx 600 index.

Quite why the views of 6,000 Belgian industrials provides such a keen insight into Europe’s equity market and economic fortunes may itself be a matter for debate on another occasion, but the results are hard to deny. The results of the business sentiment survey are released on the National Bank of Belgium’s website on around the twenty-first of each month and they can provide a succinct insight into Europe’s business fortunes.

Belgium's Courbe Synthétique is a good indicator for Eurozone equities

Source: National Bank of Belgium, Thomson Reuters Datastream

The dip witnessed following the UK’s vote to leave the EU may have been a blip although the Courbe stalled at -1.8 in November. Perhaps more progress will be required here if Eurozone equities are to make further progress in the face of tapering from the ECB.

Off target

The ability of European stocks to shrug off the Italian referendum result is a potentially positive sign although real sceptics of the Eurozone’s long-term economic fortunes still have one powerful set of data on their side – the only shame is it is published with a two-to-three month lag.

This is the Target-2 data.

Target stands for Trans-European Automated Real-time Gross Settlement Express Transfer system. In essence the system is there to help balance trade flows but it also reflects capital flows – if a Spaniard parks cash with a German bank, the Spanish bank that lost those deposits now gets Emergency Liquidity Assistance (ELA) , or funding from the ECB via an open credit line to make up for the loss of that cash. This is all well and good unless the recipients of that ELA funding default – as other EU members would share that pain.

What Target-2 data is showing at the present seems to be huge capital flight from the South to Germany and it will be interesting to see if this trend becomes more pronounced after the Italian referendum result.

The Target-2 numbers suggest the Eurozone edifice is still under considerable strain, with Germany and the select number of other creditors bankrolling the rest. It remains to be seen how much taxpayer and voter appetite there still is for this state of affairs and the 2017 German and Dutch elections will help us find out.

Only six nations are creditors under the EU’s Target-2 mechanism …

Source: Eurostat

… and the imbalances between key debtors and creditors look to be growing

Source: Eurostat

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.