Tapering's just a question of time

Since tapering was first talked about, the US dollar has strengthened and bond yields have climbed. Both of these events are what we would expect when tapering actually begins, so some markets have already priced in the reality of tapering. But it will be the magnitude of the tapering that will dictate how equity markets respond.

IG Market Strategist, Evan Lucas agrees the bond market has priced in tapering, but says the equity market is yet to. As a result, we will experience whippy equity markets until we have more clarity around tapering.

The hype surrounding taper talk seems overdone. Let’s remember America as an economy is recovering and producing meaningful economic growth. To continue economic expansion and having quantitative easing at the same time would be irresponsible over the long term, giving rise to inflationary risks.

With the next FOMC meeting not until September, volatility will succeed. Post meeting, equity markets are going to be jumpy as they digest the impact of reduced liquidity.

For equity markets to fully respond to tapering, they need further guidance from the Federal Reserve on timing and size. Lucas is tipping the September FOMC meeting will outline a tapering start in October, with a US$5 billion reduction to come from both Treasuries and mortgage backed securities.

As we have seen, the prospect of tapering has actually been more dramatic for bond markets rather than equities, as the long term yield has gradually increased (pushing bond prices down). The resulting outcome is investors should seek out better risk-adjusted returns, maintaining ongoing support for equities. Clearly if bond yields keep rising this would be disrupted.

Taper talk will dictate our market movements every time it is prominent in overseas news, which is probably going to be every day until the next meeting. For the time being, the struggles taking place in emerging markets will have a far more dramatic impact on our economy and are more pertinent. Let’s not forget who our trading partners are.

Since the first round of quantitative easing was announced in December of 2008, the S&P 500 has returned a total of 101 per cent or 15.4 per cent annualised. In comparison, the Australian market in the absence of any stimulus program has only given 36 per cent or 6.7 per cent annualised.

Perhaps it is time for US equities to return to a more normal path of growth.

Quantitative easing can’t continue to infinity and beyond. It creates an artificial environment, where asset prices are encouraged to appreciate. Asset price movements should in fact be a reflection of intrinsic value based on underlying fundamentals.