Why tapering should be seen as good for equities

Tom Stevenson, Fidelity, 21 August 2013

*This week Tom's column was written by Shahzad Farooq*

Global markets remain fixated on the question of when the US Federal Reserve will begin tapering its $85bn a month bond-buying programme. The debate about whether this will happen in either September or December looks sure to intensify after the minutes of the Federal Open Market Committee’s July meeting are released today.

While less Fed buying is clearly a valid source of concern for bond markets, (though much less so at current increased yield levels), equity markets’ fears about this appear less reasonable. Firstly, the numbers speak for themselves – in the three months or so since Fed chairman Ben Bernanke first mentioned the notion of “taking a step down” in bond purchases, the S&P 500 index is up by more than 5%, while Germany’s DAX index has surged ahead by 10%.

Secondly, the really key point to remember is that the US economy is clearly improving and it is precisely this surer footing which is allowing the Fed to begin contemplating a relaxation of its emergency monetary support measures. In fact, given the economic recovery, it should actually be a bigger concern for investors if the Fed were to persist with its highly unusual quantitative easing policy.

As the Fed begins reducing the amount of its bond purchases, it is to be expected that bond yields will rise. In fact, we know that bond yields have already risen substantially in anticipation of the Fed tapering its purchases. The rational basis, if any, for equity investors to worry about higher bond yields is the resulting increase in borrowing costs, of US mortgages for example. However such effects need to be weighed up against all the positive effects of a strengthening economy. For example, we can imagine a company that is facing rising debt costs but also improving sales.

History can be a useful guide on this question, because in the past there have been many episodes of rising bond yields. The message from this is clear – generally, when bond yields are at low levels (as they still are now) and they begin to rise, then this very often tends to be associated with rising rather than declining equity markets. A more technical way of saying this is that ‘equity returns and bond yields are positively correlated at low yield levels’. A recent Morgan Stanley research note made a very similar point by noting that ‘multiple expansion occurs with higher real rates’.

Whichever expression one chooses, it is clear that our most recent period of rising equity markets and rising bond yields is entirely consistent with history. In the case of our hypothetical company that is facing rising borrowing costs but also rising sales, it would appear then that the latter factor tends to dominate the former.

While most developed equity markets have performed strongly in an environment of rising rates in line with the historical precedent just outlined, it is worth noting that the opposite has been true of many emerging markets, with the so-called BRICs countries faring particularly badly of late. This should not be surprising.

In short, we know that a key driver of good emerging market equity performance in recent years has been large inflows of money from investors seeking better yields compared to the artificially depressed ones that were seen in developed markets. Now that yields have begun to rise to more normal levels in places like the US, Germany and the UK, on a relative basis, it is understandable that emerging market assets might appear less attractive.

This said, the short-term issue of bond yield normalisation in developed markets should by no means detract from the many long-term attractions of emerging markets, which remain intact. Indeed, the recent sharp declines seen in emerging markets to historically very cheap levels in some cases, very likely spells opportunity for long-term investors – a possible subject for a future column!

Note the value of an investment and the income from it can go down as well as up, so you may get less than you invested and tax rules and allowances can change. The ideas and conclusions in this column are the author's own and do not necessarily reflect the views of Fidelity’s portfolio managers. They are for general interest only and should not be taken as investment advice or as an invitation to purchase or sell any specific security. Past performance is not a guide to what may happen in the future and the figures and returns in this article are purely to illustrate the author's points.

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