Dr Walter T. Molano, Guest COLUMNIST
With the end of the third quarter moving into the rear-view mirror, we are on the last lap of what has been a pretty painful year.
Fortunately, most fund managers were well prepared for the steepening of the US Treasury curve. By the end of 2012, the United States economy was showing signs of life, thanks to the fracking revolution and the recapitalisation of the US financial system—which led to a revival of the housing market.
Even though money was still pouring into the emerging markets, most fund managers began anticipating an eventual correction by reducing duration, moving into higher-quality credits and raising cash levels.
The day of reckoning finally arrived at the end of May when US Federal Reserve Chairman Ben Bernanke mooted the need to taper the quantitative easing programme (QE) before the end of the year.
Although the subsequent sell-off was painful, it was not a bloodbath—but it could have been. Trading liquidity is a fraction of what it was a few years ago, thanks to the implementation of the so-called Volcker Rule, new capitalisation targets and the refusal of bank equity shareholders to take unnecessary pain.
Fortunately, portfolio managers used their stockpile of cash to meet redemptions. This averted the panic selling that could have occurred.
Nevertheless, the correction marked the start of a prolonged summer of thin liquidity, low trading volumes and dormant capital markets.
The summer doldrums also provided two new revelations. The first was that the US recovery was much shallower than initially thought. Both growth and inflation were tracking below expectations, and the jobs market was losing steam.
Moreover, the sharp increase in mortgage rates, thanks to Bernanke's tapering comments, had grim implications for the future of the housing market.
The second development was the unexpected revival of the Chinese economy. Left for dead earlier in the year, it made a surprising comeback during the third quarter. Although Beijing claimed that the miraculous resurrection was due to the mini-stimulus package, it looked like the government went back to its old policy of using state-owned companies to drive up demand by embarking on needless infrastructure projects.
The Chinese turnaround led to a pickup in commodity prices, and many fund managers were anxious to jump back into the fray.
The redemptions were not as bad as initially thought, and there was spare cash on the table. Performance was also poor, and there was a pressing desire to save the year. However, they needed a green light from the Fed. There were already signs that any tapering would be minimal, but when the Fed decided that it would delay the measures, fund managers decided to move.
The next few months promise to be interesting. The Fed will surely try to talk down the market, but with more fiscal drama on the horizon, a possible slowdown in housing and a new Fed chairman waiting in the wings, I think that there will be no tapering for the rest of the year, which should allow fund managers to put their money to work, drive up EM prices and lock in a nice Christmas bonus.
Yet, one thing bothers me. Many fund managers are basing their investment decisions on the variable of whether Treasury yields will go to 2.5 per cent or 3.0 per cent. Unfortunately, this is the type of decision making that is done when making investments in high quality spread products. Not risky assets, like emerging markets.
To make matters worse, EM is in for a very ugly ride. The Fed's decision not to taper, only postponed the inevitable.
Monetary policy in the US will tighten next year and the Chinese juggernaut is losing steam, thanks to an increasingly overvalued currency. Eventually, Beijing will throw in the towel and devalue.
These two events will create a perfect storm. At that time, EM will no longer be a spread product, where investors will be squeezing a few basis points of carry over a low-risk fixed-income asset.
Instead, it will revert to becoming a price product, where investors will try to bet on the highest recovery value of an asset in a treacherous minefield.
Dr Walter T. Molano is a managing partner and the head of research at BCP Securities LLC.email@example.com