Please see below article received from Legal & General yesterday afternoon, which reviews the markets’ reaction to the disorderly withdrawal of US and UK troops in Afghanistan and the ongoing global battle with coronavirus.
Last week, we received the minutes of the Federal Open Market Committee (FOMC) meeting held at the end of July. Tapering was the word of the day. A reduction in the pace of asset purchases is now overwhelmingly expected by the year’s end. When thinking about the risks to global markets posed by tapering, we believe it is worth remembering three things.
Minutes minutiae
First, never has a pending policy change been discussed so much, by so many, for so few insights. Market shocks tend not to be driven by things that are almost entirely predictable.
Second, aggressive tapering happened last year, and nobody really noticed. In the first three months of the COVID-19 crisis, from March to May 2020, the Federal Reserve (Fed) bought $1.6 trillion of Treasuries. In the subsequent 14 months, it has bought just over $1.1 trillion. The pace of asset purchases has slowed down by 85% since those early days. Since then, the S&P 500 is up over 50%, credit spreads are tighter, and real yields are lower. Anyone arguing that asset-purchase flows are the “only game in town” has a tough time explaining that.
Third, the 2013 taper tantrum was a stressful time for emerging-market investors, but a non-event for investors in US equities. The S&P 500 had a peak-to-trough drawdown of 5.5% in the middle of 2013. That’s it.
So, what could a genuine tapering surprise look like? The potential action is not in the timing but in the pace. Last time around, tapering took 10 months; formally announced in December 2013, it ran until October 2014. It was then another 14 months from the end of tapering to the first rate hike, so it was a two-year process before we reached the serious business of rate hikes.
We think the timelines can be compressed this time around, but still struggle to see the conditions for a rate hike before mid-2023. Even the most hawkish voices on the FOMC are talking about end-2022 as the likely “lift-off” date.
That means that the real yield on cash (almost certainly) and on government bonds (probably) will remain deeply negative for the foreseeable future. There is plenty of discussion about overvalued equity markets, but the forward earnings yield on the MSCI World is still in the region of 5%. That looks mighty tempting in a world with $16 trillion of negative-yielding debt.
Regime change in Afghanistan
The world has witnessed incredibly dramatic scenes in Afghanistan. But what pointers are markets taking from the collapse of the Western-backed government?
The Afghani currency has tumbled by nearly 10%, but it is too exotic for even the most high-octane frontier market funds. It is impossible to know how the unfolding tragedy will evolve, but the markets are adept at drawing dotted lines from one political theatre to others. We can think of three implications:
- It raises immediate concerns about the pending withdrawal of US troops from Iraq. The combat mission there is due to end by December, with the remaining 2,500 US troops leaving. Given that Iraq produces the best part of four million barrels of oil per day, political instability there has a firmer transmission route to global risk sentiment than Afghanistan.
- The effectiveness of the US deterrent in other parts of the world has arguably been undermined by the rapid withdrawal of support in Kabul. In particular, China’s state media have immediately drawn the link from Kabul to Taipei. The Global Times has been quick to play up the “unreliability of US commitment to its allies”, arguing that in the event of war “the island’s defence will collapse in hours and the US military won’t come to help”. This is not exactly subtle messaging, but it does force markets to think harder about the superpower tensions.
- During the 2014-15 migrant crisis, the European Union received 1.6 million requests for asylum. We think of that migration wave being a consequence of the Syrian civil war, but roughly one-sixth of asylum seekers were from Afghanistan and Pakistan. Three years ago, we wrote about the potential for uncontrolled refugee flows to act as a catalyst for higher political risk premia across Eastern and Southern Europe. Asylum policy is set to become a divisive political issue once again, with worrying implications for French and Italian politics. “Le spread” and “lo spread” will be the centre of the market’s attention before long if refugee flows are not well managed.
Kiwi fails to take flight
New Zealanders are pioneers in many things: kiwifruit, rugby, manuka honey. But they are also world leaders in central-bank innovation. The Reserve Bank of New Zealand Act came into effect in 1990, and it wasn’t long before the innovation of “inflation targeting” spread all the way around the world.
Since the pandemic, its innovation has taken two forms: formally adding a housing concern to its policy mandate, and acting as the frontrunner in the move to normalisation. At the beginning of last week, the market assumed the first increase in rates since 2014 was a foregone conclusion. That confidence was derailed by COVID-19.
Since February last year, New Zealand has reported just under 3,000 COVID-19 cases with fewer than 30 deaths. The “zero COVID” strategy has been immensely successful but requires an aggressive response to even the smallest incidence of community transmission. Re-imposing a lockdown across the country triggered a 2.5% swoon in the New Zealand dollar and saw expectations of rate hikes pushed back to later in the year.
The risks here are evident across the Tasman Sea, where COVID-19 cases in New South Wales continue to double every 10 days despite a lockdown now entering its 10th week. Sydney is in a trap with no obvious escape route. The markets have to price the risk that Auckland will soon be stuck in the same bind.
This is a reminder that currencies remain pretty sensitive to developments in interest rates. Interest-rate differentials have not been a factor for several years because G10 interest rates haven’t been moving. That could change in 2022, with some early movers starting to normalise.
The skew of risks around the interest-rate path outlined by central bankers also remains to the downside. Despite lots of rhetoric about inflation concerns, last-minute worries about growth can still kibosh hiking plans.
Finally, zero-COVID strategies require constant vigilance. There’s an obvious read across here to China. The news there over the past week has looked better, with case numbers declining again, but trying to keep a highly infectious disease out of the country altogether will be an ongoing battle with economic collateral damage. Our China outlook for the rest of the year is notably more downbeat than the consensus as a result.
We will continue to publish relevant content and news as we enter the final couple of weeks of summer in the UK.
Stay safe.
Chloe
24/08/2021