North American investors have been worrying about Europe
for much of the recent past. Now, they have to worry about Asia as well.
Concerns about China’s efforts to tighten its financial policies
and reign in lending are dominating much of the market chatter these
days, but it is Japan that really has some participants spooked.
Christine Hughes, president and chief investment strategist at
Toronto-based OtterWood Capital Management, thinks the math behind Japan’s
monetary policy paints a very dire picture.
“Their policies have made the recent bond market carnage worse than it
otherwise would be,” she said. “Japan’s printing program effectively drove
rates lower across the globe via the yen carry trade. When Bernanke laid
out the plan for winding down QE3, the bond market panicked.”
The two-year plan recently unveiled by Japanese Prime Minister Shinzo
Abe includes aggressive quantitative easing through unprecedented bond
purchases – some US$70-billion per month – to double the amount of money in the
system as part of an effort to achieve 2% inflation.
“Nobody doubles the amount of money in circulation in two years,” said
Ms. Hughes, who manages three mutual funds for NEI Investments, including the
NEI Northwest Macro Canadian Asset Allocation Fund.
She also notes Japan is the second-largest bond and currency market in
the world. “You don’t do that unless you’re totally desperate, so the fact that
they are doing it tells you just how little time they really have left.”
The Bank of Japan’s aggressive monetary policy (via the carry trade)
effectively suppressed interest rates, but they spiked after the Federal
Reserve outlined its withdrawal plans.
“All of these conflicting policies caused great confusion in the bond
market,” Ms. Hughes said.
She explained the movement in rates has been exacerbated by a phenomenon
called convexity hedging, whereby bond managers are essentially forced to sell
in order to hedge against existing losses.
In this case, U.S. mortgage-backed securities were falling in value,
while U.S. 10-year Treasury bonds were being sold to hedge these losses — a
correlation that is generally high.
“The tough part is the thing you have to sell to hedge is usually tied
to what you own that’s going down, and it’s falling too,” Ms. Hughes said.
“You’re selling into a falling market to hedge, and everybody else is doing
that too.”
China’s credit squeeze and Federal Reserve chairman Ben Bernanke’s plan
to potentially reduce the U.S. central bank’s bond buying have further rattled
financial markets.
“China’s new government is basically saying no more, because they are
trying to get a hold on their own wealth management products and excess
leverage in the second-tier banking sector,” the strategist said.
“It’s made worse by Japan, where the currency has fallen 25% since late
2012. This is an enormous drop in a short amount of time and large swings like
that are very destabilizing for global economies and markets.”
China’s leaders are clearly willing to take some pain in the short term,
but the spillover has dragged down all things rate-related, including
high-yield bonds and emerging markets in particular, but also REITs and other
bond-like sectors.
For now, Ms. Hughes thinks the emerging-market and commodity trades are
clearly broken. They will have their day again, but she sees much more value in
U.S. equities.
“If you look at year-to-date returns, [U.S. equities] are really the
only thing that’s up, and I don’t think that’s going to change a whole lot,”
she said. “It will remain the best place to be, because people didn't expect to
lose this kind of money in bonds.”
Ms. Hughes also expects Canadian stocks to remain challenged,
particularly given the S&P/TSX Composite index’s heavy weighting in
commodities and consumers’ high leverage.
“Our banks are slowing,” she said, noting four of Canada’s big six banks
missed on earnings in their most recent quarter. “So something is changing
there too.”
ething is changing there too.”
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