THE United States Federal Reserve's decision last week to maintain the size of its quantitative easing (QE) at US$85 billion a month has created positive conditions for a relief rally in risk-asset markets. Equities in both developed and emerging markets will benefit from the decision, as pent-up liquidity is pushed back into play.
To begin with, there had been an over-reaction to the impact of tapering on the US Treasury market since May. As we had said before, an earlier tapering by, say, six months could - depending on the size of the cuts in Fed spending - amount to anything between US$75 billion and US$120 billion in asset purchases.
That would be something in the region of only 10 per cent of an entire year's quantitative easing. From recent years' experience with the impact of quantitative easing on US Treasury bond yields, that should in theory not amount to much more than 10-20 basis points in the 10-year US Treasury yield.
But the market over-reacted, pushing the 10-year yield from around 1.6 per cent in early May to 3 per cent early this month.
Enjoy the likely upside volatility while the going is good. Beyond this 'feel good' from the delay of tapering, the funda- mentals have not changed.
The Federal Open Market Committee (FOMC) decision last week triggered a correction of that over-reaction, and this most likely will continue over the coming weeks. Along with that, equities will also most likely push higher across the board. This will fuel a continued rebound in oversold emerging markets.
But tapering is inevitable; it's only a question of timing. The decision to delay it may create more volatility, both on the upside and downside - that is, risk-asset markets will most likely rally on the continuation of the status quo in Fed buying of US Treasury bonds and mortgage-backed securities.
Indeed, economists are now starting to shift expectations of the commencement of tapering to March 2014. This new optimism on continued plentiful liquidity could sow the seeds for disappointment and a sharper correction down the line.
But for now, enjoy the likely upside volatility while the going is good. Beyond this "feel good" from the delay of tapering, the fundamentals have not changed. This is about fund flows, which can be fickle. The global economic growth outlook is improving, albeit in fits and starts.
The US economy continues to chug along at a moderate pace of growth despite programmed government spending cuts ("sequestration"). The European economy is in cyclical recovery from its worst post-War recession. China appears to have seen the bottom of its economic growth cycle. Even Japan seems to be gradually moving out of deflation - economic activity is certainly growing again. Globally, corporate earnings will probably continue growing, albeit at a slower pace than in previous years.
For all the funk over tapering of quantitative easing - simply a diminution of the size of Federal Reserve support for US Treasuries and mortgage- backed securities - interest rates are still at punitively low levels. They are certainly a long way from where it would make sense to hold cash for any extended period of time.
All the above are supportive of a continued uptrend in global equities, particularly developed market stocks.
But for emerging markets, the current account deficit economies remain at risk of renewed stress if fund flows reverse - as they are most likely to, as US Treasury yields eventually move back up again in response to a strengthening economy and eventual tapering of QE.
What the fundamentals mean for the market outlook is that funds will be more demanding and discriminating. Zooming out for a bigger-picture view, the following trends emerge:
Remember, tapering of quantitative easing has been postponed - not taken off the table. That postponement will most likely increase volatility both ways.
Investors should focus on emerging market economies with the strongest fundamentals. This is the differentiation theme within emerging markets.
My preference is emerging market economies with current account surpluses, large international reserves relative to gross domestic product (GDP) and imports, relatively low external debt relative to GDP, relatively low net international bank claims and relatively stable currencies.
Asia ex-Japan plays better to that theme than Latin America, Turkey and South Africa. And North Asia (China, Hong Kong, Taiwan and Korea) and Singapore play better to that theme than South-east and South Asia.
The Chinese equities market is trading at global financial crisis lows in valuations. It is base-building, awaiting a catalyst for higher prices. The downside risk appears limited at these levels.
The catalyst could come from:
Taiwan and Korea may benefit from the strength of the technology markets and play catch-up with the Nasdaq.
Singapore is vulnerable should there be a systemic crisis in Indonesia. But its massive current account surpluses, large international reserves, well-governed markets, rule of law, transparency of corporate earnings and global economic linkages are all hallmarks of quality that will hold it in good stead.
In line with the "differentiation" theme, investors might also want to update their opinion on European equities. As the fundamentals of some emerging market economies deteriorate, Europe has been in quiet repair mode. Structural repairs to government debt and deficit are taking place, albeit slowly. Primary balances have improved dramatically over the past few years in the peripheral European economies.
Current account deficits have reversed dramatically in Portugal and Spain. Consider this: Spain's current account was in a small surplus of 0.66 per cent of GDP in June; Portugal's current account was also in a modest surplus of 0.15 per cent of GDP.
Consider that against Indonesia's deficit of 4.4 per cent of GDP. The risk premium in European equities remains historically high, although it has come off quite dramatically since European Central Bank president Mario Draghi promised to do "whatever it takes" to stabilise the government bond markets.
Prices should continue to rise as that risk premium declines further. As the European economy continues to recover, corporate earnings - which had been lagging the earnings recovery in the US - could play catch-up with the US.
European equities have underperformed emerging markets since 1998; 1997 was the last time the ratio between the two indices was where it currently is. That ratio put in an extended base build from 2010 and appears to be reversing (see chart above).
In short, Europe could outperform emerging markets for quite some time to come. Valuations - price-to-book and price-to-earnings - are still close to long-term lows. The MSCI Europe Index price-to-earnings ratio is close to a 30-year low. Quite literally, this is a once-in-a- generation valuation opportunity.
Where do you fund these investments from within your portfolio? Out of bonds. The rotation of funds out of fixed income into equities will continue.
Indeed, turning points in 10-year US Treasury yields have typically been associated with positive returns for equities for the subsequent 12 months. Balanced portfolios should continue to shorten duration against the risk of higher rates globally.
The writer is chief investment officer for Group Wealth Management and Private Banking, DBS Bank