Quantitative tightening: what will be its impact in 2010?

The big story of 2009 was quantitative easing; the big story of 2010 will be quantitative tightening.

There are two big questions for investment managers. When will it happen? And what will be the impact?

In our view there is little doubt that quantitative tightening will begin this year. In fact, it has already started in some economies.  We have been monitoring, collecting and analysing liquidity data for over 25 years – our monthly databases cover some 80 countries and extend back to the early 1960s.

The lessons we have learned from that data we apply to our own funds. They could make a significant difference to investment outcomes in the coming months.

• Quantitative easing (QE) and tightening (QT) are not new phenomena. Every financial crisis in the past 50 years has been preceded by a liquidity slump. And each has been followed by a sharp liquidity recovery, much like today. There have been nine major liquidity slumps in that half-century.
• Quantitative tightening always follows quantitative easing. Liquidity is cyclical and fluctuates over a four-year or five-year duration.
• Generalising, we can say that asset booms and asset bubbles top-out within one or two years of a peak in the global liquidity cycle. Similarly, banking crises occur within one to two years of a liquidity trough.
• The geography of each banking crisis is always different. Sometimes it is Asia, sometimes Europe and sometimes the US.
• Equally the character of each asset boom differs. One cycle may feature a surge in commodity prices (1974), another gold (1980). Emerging equity markets (1993) may become the focus of the mania, or it could be technology shares (2000) or real estate prices (2006).
• Asset markets tend to be affected by liquidity sequentially, starting with government fixed income (one to three months after a turning point), moving on to precious metals and currencies (three to six months), and ending with equities (six to nine months) and real estate (nine to 12 months). We call this process the Investment Clock.
• Bonds/yield curves are the first ‘price’ to be affected by liquidity; the exchange rate is the most important ‘price’, and equities are the most sensitive ‘price’ to liquidity.

Predicting the tightening timeline

So reflect back on 2009 and you will see the markets moved with a remarkable precision in line with our clock. In short this liquidity cycle has been no different from any other one.

What about the future? Our latest data shows what many of us know already – quantitative easing is slowing. The global liquidity cycle has peaked but its continuing high level still points to some further asset price gains.

So when will quantitative tightening begin? The US was first into the easing process; it will be one of the first out.

Most pundits seem sure that the US Fed is unlikely to tighten monetary conditions in 2010. We are less convinced. The standard argument is the likely absence of significant US CPI inflation next year, combined with persistently high unemployment, will prevent the US Fed from moving. However, while it may well be true CPI inflation will remain subdued this year, the plain fact is, historically, the US Fed has never acted against CPI inflation per se. Rather its monetary attacks have always been launched against domestic commodity price inflation, items such as rising food and energy prices.

So the hike in US dollar commodity prices since March 2009 has dramatically raised the odds of upcoming monetary tightening, and that is consistent with the messages coming out of the Fed.

Impacts on asset classes

Looking ahead, I think we will see a large-scale jump in US corporate profits over the first two quarters of 2010. The short-term economic outlook will likely favourably surprise the pundits. The combination of this with a pinch of quantitative tightening will see investment flows back towards the US and propel the dollar higher through the year.

That will have a negative impact on two of the leading asset classes of 2009: commodities and emerging markets.

Our data shows there has always been an inverse correlation between the US dollar exchange rate and both commodity prices and emerging markets.

If commodities look set to fall in value, it seems highly likely the 2001-09 bull market in gold will also be significantly dented. We think the US dollar gold price will fall back if the US dollar rises, and it could skid all the way down to $900/oz again. In short, 2010 could prove the severest test for the gold bulls this decade.

That does not change our long-term view of commodities and emerging markets. Do not confuse trend with cycle. The long-term trend for both is upwards.

We expect emerging economies to grow in real terms at close to 5% a year, compared to less than 2% for the West. Compound growth means that the West will therefore double in real economic size around every 70-or-so years, compared to a doubling of emerging economies every 15 years. It is a huge growth gap.

The latest calculations of market size put emerging markets at around one quarter of world market capitalisation. We estimate by 2030 the current emerging markets will account for nearly two thirds of world GDP and should make up close to one half of global stock market value. Large-scale capital flows are likely between the West and the emerging markets as our investors scramble to build up their exposure. This will itself have a bootstraps effect, forcing asset prices higher and lifting emerging market exchange rates.

So though we are anticipating a 10%-15% correction in emerging markets this year, the long-term case is so strong you should think of it as a buying opportunity.

The year ahead

Finally, returning to the investment clock, bonds were first to benefit from the post-Lehman monetary stimulus, and they should be first to be hurt when the punch bowl is removed, inflation or no inflation.

Looking at the year generally, then, rotation is the watchword for 2010. It makes sense to close US dollar shorts, reduce duration in bonds, and maybe look to trim positions in emerging market shares and gold in favour of US technology. An outside bet for 2010 is Japan. If the government there devalues the yen and introduces further monetary stimulus it could inject some life into Japanese markets.

But the advice with Japan is the same as ever – watch closely but don’t hold your breath waiting for the government to do the right thing!

Michael Howell, managing director of CrossBorder Capital