Today, macro factors, both on the political and economic fronts, will play a decisive role on the future direction of asset prices. From the political wrangling over the US Debt ceiling to timing and the speed of weaning the US and world economies from easy money, the next few months will be tricky and difficult to navigate for both investors and traders. Below I will provide a list of the five most important points to consider in this unfolding drama.
- Expect a delay towards ending easy money. If the Fed committee was indecisive on when to end tapering as noted in the FMOC minutes. Then the political uncertainty introduced by the current stalemate over the US Debt Ceiling will certainly increase Fed indecisiveness. The result will be a delay in the tapering decision. First of all, the timing for such a move would be wrong immediately following a positive resolution to the US Debt Ceiling and it would be catastrophic if no US Debt Ceiling agreement were reached. Thus, no matter the result, the Fed will delay. Additionally, there is transition to a new Fed chairperson with Janet Yellen being nominated for the role. Expect things to slow down as this transition takes place and the dovish bias in monetary policy to continue. As discussed in a previous article this will be very good news for emerging market ETFs such as India (EPI), Turkey (TUR) and Indonesia (IDX) which have high current account deficits. A Moody’s report as published in the WSJ, also mentions India, Turkey, and Indonesia. In addition Brazil (EWZ) and South Africa (EWY) are added to the list of countries with high current account deficits which are the most vulnerable to a Fed pullback. Other emerging markets ETFs such as: iShares MSCI Emerging Markets ETF (EEM), Vanguard (VWO), iShares China Large-Cap ETF (FXI), Mexico (EWW) and Market Vectors Russia Index ETF (RSX) should benefit.
- The Fed will take into consideration the global economy. See a recent article in the WSJ regarding some of the complexity of a tapering decision due to an interconnected world. Other reasons are simple. The world economy has not recovered yet and is still very fragile. I would still consider that we are in a crisis period with varying degrees depending on the region/country in question. However the situation is improving. Crises are difficult to compare and predict (see my academic article, ‘To What Extent are Financial Crises Comparable and thus Predictable?,’ also accessible at the Munich RePEc Archive). Managing an exit strategy from crises, especially such a significant one, definitely requires some coordination among monetary authorities globally. The recent WSJ article from the IMF warning of the 2.3 Trillion hit in the bond markets is a reminder that withdrawing from easy money will not be easy and needs to done with extreme care.
- Considering the two points above, the Fed will proceed with caution and decisions will be delayed. Consumer and business confidence will play a role along with the market reaction. Will the Fed end easy money? The answer is definitely yes. What we need to figure out as investors and traders is not only when but more importantly how fast. I think the when question is the easier of the two to answer since it will not happen this year, thus I would look at the first quarter of 2014 as the beginning of the end of easy money policies. Now the how fast part is the more interesting question and this question has bigger implications for financial markets. If they do it too quick then markets will dive and consumer and business confidence will turn negative which might derail the recovery.
- How fast the era of easy money is wound down will have both economic and political implications globally. Election outcomes in some countries will certainly depend when and how fast this easy money is wound down. A good example here is Turkey (TUR). With elections in the spring of 2014, will a stronger or weaker government emerge in Turkey? What implications does that have for the Middle East considering the mess in Syria and Egypt along with the Iranian nuclear question? Does this improve or weaken the position of Israel? How does this impact the price of oil? The point here is that all these events are interrelated in some way.
- Although I bring this issue up last, it is actually the most important in the short-term. How will the US Debt Ceiling debacle get resolved? This is a difficult question to answer. But let’s quickly review what is at stake here. First, a US debt default will be a disaster and lead to a sharp downturn in financial markets. We would certainly face another crisis and recession globally. Second, China and Japan would not be too happy and their exit strategy will be complicated by the fact that there are few places to turn outside of the US dollar plus selling their own assets will further deteriorate values. What this means is that in the short-term it might not be as bad as some forecasts but in the long-term US reputation will suffer and alternatives will spring up such as the Chinese Renminbi, etc. The process will speed up. Thus, the US will be on the road to losing the benefits that come with having the world’s reserve currency. Third what will happen to prices in important commodities such as oil which are priced in US dollars? And did I mention the havoc this would cause on several countries worldwide that use the US dollar, such as the Arab Gulf States – Saudi Arabia, Kuwait, Bahrain, etc. These are important US allies. Fourth, the politicians would get blamed. At this point, it looks as if most of this blame will fall on the Republicans. For these reasons and many more, I do not think a default will occur. The politicians will find a way out. There is simply too much at stake to not strike a compromise. In short, default will not happen. As we get closer to the Debt Ceiling deadline, the pressure will increase on the politicians to strike a compromise. Therefore, contrary to popular belief the probability of default risk will get smaller not larger as we get closer to the deadline. A good trade here would be to go short any volatility products (VXX). In other words, when volatility spikes, you should take a very short-term position that volatility will soon fall.