Fed tapering: who would suffer, who would gain?
As fears rise that the Fed might start reining in its money-printing sooner rather than later, analysts look at the most – and least – vulnerable markets
As last week Federal Reserve Chairman Ben Bernanke seemed to hint that quantitative easing could be coming to an end quite soon, market nerves and volatility have increased.
Memories of previous occasions when the punch-bowl of central bank stimulus had been taken away resurfaced, with many analysts warning of a repeat of those scenarios.
"A sharp rise in rates that hurts bank stocks and the dollar would be risk negative, as was the case in 1987 (equity crash) and 1994 (bond crash)," strategists at Bank of America Merrill Lynch wrote in a market note.
"A host of 'canaries in the bond-mine' (mortgages, REITs, utility stocks, lumber) are indicating that markets are getting nervous about QE tapering, and suggest the next move in bond yields is more likely to be up than down," they added.
This increases the risks to emerging markets because of potential portfolio outflows, according to strategists at Nomura.
They expect their three key emerging regions Emerging Europe Middle East and Africa (EEMEA), Asia and Latin America to react differently to a withdrawal of stimulus and structural strength in the US dollar.
Firstly, they said in a special report outlining the potential effects of QE tapering, "it is worth noting that the Fed is still purchasing and we are looking at an adjustment in size because of positive factors (better growth in the US) in the absence of inflation, while the ECB and BoJ remain dovish."
"At this stage, the low inflation backdrop does not create a sense of urgency to unwind the stimulus," they added.
In Asia, the most vulnerable currencies to the risk of portfolio outflows are those where current account positions are relatively weak, according to the Nomura strategists.
They identify the Indonesian rupiah (IDR) and the Indian rupees (INR) as facing "notable depreciation pressures." The Malaysian ringgit (MYR) is also vulnerable because of the country's small current account surplus.
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The least vulnerable, in the Nomura analysts' opinion, is the Chinese yuan (CNY), followed by the Taiwanese dollar (TWD), Korean won (KRW), Thai baht (THB) and the Philippines peso (PHP); but the KRW and the TWD are vulnerable to a depreciation of the Japanese yen (JPY).
In Latin America, most economies, except Mexico, "have growth models heavily dependent on strong terms of trade and capital inflows," the Nomura analysts noted.
In some countries, such as Chile, Colombia and Brazil, current account deficits are widening "as falling terms of trade generate greater financing needs," they said.
"A stronger US dollar in the context of a tapering expansion of the Fed's balance sheet and flattish commodity prices promise that there will be challenges ahead."
They warn about a "winner's curse" in the region, with countries that received the most inflows of portfolio investment seeing their currencies depreciating the most, despite having relatively stronger fundamentals.
Brazil and Mexico are examples of this, but for Mexico the situation should improve as markets realize that it would be "one of the primary beneficiaries of firmer growth in the US."
In EEMEA, "one country with a risk of portfolio outflows is South Africa," according to the Nomura analysts.
"We believe ZAR [the South African rand] is the most vulnerable, as South Africa's current account is quickly deteriorating and its long-run fiscal picture has also been worsening over the past few years," they said.
The strategists noted that Turkey has been the highest recipient of inflows in the past three months in the region, with $4 billion, of which $3.8 billion was in bonds.
"Hence, despite our very bullish view on Turkey upgrades and its improving current account, we realize that sharp inflows could keep it at risk from unwinds," they said.
They noted that Poland followed Turkey with $3.7 billion of inflows, of which $2.6 billion were into bonds, and Russia received $3.1 billion in bonds over the past three months but saw $1.1 billion in outflows from equities.
But the strategists added that they were not too worried about Eastern Europe, because it has "historically proven to strengthen on US rates sell-off as these episodes have been accompanied with positive risk sentiment."
Strategists at Goldman Sachs point to European stocks as possibly benefiting from the latest move in US Treasury bond yields, which have risen recently.
"Provided it is better growth that is driving yields upwards (which is what we expect) we would argue it is supportive," they wrote in a research note on Europe. "We find a positive relationship between real yields in the US and European equities."
They expect the Federal Open Markets Committee to start shrinking QE in the first quarter next year and the first increase in the Fed funds rate in early 2016.
The Goldman Sachs strategists also noted that the correlation between the performance of European equity markets and moves in bond yields has been positive since 1999, as higher yields "have been synonymous with stronger growth."
They do not believe a repeat of the 1994 scenario is likely as "the equity market was more vulnerable [then] than today.""We still see the most likely outcome as a modest rise in bond yields and reasonable returns on equities," they said.
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