Last updated: 07:30 / Thursday, 2 January 2014
UBS Global AM

I will not confuse tapering with tightening: the biggest resolution for 2014

I will not confuse tapering with tightening: the biggest resolution for 2014

It is once again time to consider some New Year’s resolutions for the market. What mistakes or misunderstandings did the market make over the last year that it should learn to avoid in the future? UBS Global Asset Management gives its suggestions.

1. I will remember that stability is not always a good thing. “At the start of the year we noted that the market had stopped reacting to political uncertainty very much, in both the US and the Eurozone. Investors had become habituated to the risks and learned to ignore them. Paradoxically, ignoring the risks can actually increase the risks. Sincepoliticians usually only change things when there is pressure from outside influence like market volatility, the problems do not get addressed. Just look at how a lack of volatility in Europe has also meant a lack of progress on structural reform and banking unión”.

2. I will not confuse monetary policy catch-up with a currency war. When the Bank of Japan (BOJ) announced ultra-loose monetary policy at the start of this year, there was much talk of currency wars, as if Japan was unfairly pushing down the yen to improve its competitiveness. UBS Global AM thinks that “a more realistic assessment would be that the BOJ had kept monetary policy far too tight in the face of both domestic deflation and foreign countries’ ultra-loose monetary policy. This meant that the BOJ was only catching up”. Wars have casualties, and in a currency war the first casualty is inflation – not something for Japan to worry about.

3. I will not confuse tapering with tightening. This has to be the big one of the year. When Ben Bernanke first announced that the Federal Reserve might start tapering its asset purchases under its quantitative easing (QE) programme, the market got over excited and translated this into earlier tightening. This was despite Chairman Bernanke insisting that tapering was simply a slower pace of easing. By September, the market pushed rates up so high that the Fed had to cancel the planned September start of tapering because financial conditions had become too tight, but finally followed through in December.

4. I will place more trust in forward guidance. The markets have tested central banks several times on their commitment to forward guidance, but central banks have stood firm. Markets do not have to believe that forward guidance will achieve the desired outcome in the long run, only that the central banks will stick to it as long as their forecasts are right. “And that is the key: feel free to disagree with the central banks’ forecasts, but trust them on how they say they will react to the data. The Bank of England is likely to be the first to be challenged simply because the unemployment data is turning out much better than its forecast”, comment Joshua McCallum, senior Fixed Income Economist in UBS Global Asset Management, and Gianluca Moretti, Fixed Income Economist.

5. I will start to ignore political bickering in Washington D.C. When the bipartisanship in the US ‘shut down’ the government and threatened a default on US Treasuries, the market talked a lot about the potential damage. In the event, the partial government shutdown had little impact on the economy and the default turned out to be the empty threat that it always was. The world continued, but the uncertainty may have held back the all-important recovery in business investment. The hope is that eventually businesses will become so used to the bipartisanship that they start to ignore it.

6. I will treat emerging markets as emerging. After the Fed announced the idea of tapering, some of the biggest market moves were in emerging markets (EM). Investors were treating emerging markets almost as safe havens, and capital searching for yield found a home there. Some EM used the capital inflows prudently, while others enjoyed the good times and saw their current accounts deteriorate. As soon as it looked like the QE tap might be closed, those markets saw their currencies dive. For a brief moment it looked like investors remembered that EM are risky, but promptly forgot all about it once tapering was delayed. Investors would do well to think again for this new year.

7. I will not complain when I get what I wish for. A year ago the markets were complaining that rebalancing of competitiveness in the Eurozone was not happening because inflation was too high in the periphery (pushing up the price of their goods relative to the core). Now that there are finally signs of an internal rebalancing with lower inflation in the periphery, markets are complaining that the Eurozone is heading for deflation. In fact, not much has changed between the two years – inflationary pressures were already low in the periphery while headline inflation remained high mostly because of increases in sales taxes.

8. I will not obsess about house prices. Too many people seem to think that rising house prices are a good thing in and of themselves, rather than being a symptom of a stronger economy or at least of a stronger economic outlook. Rising house prices are good for those who own houses but bad for those who do not and would like to.

9. I will prefer the simplest of similarly plausible explanations. Just as optimists invent many theories to explain why a bubble can go on forever and why ‘this time is different’, after a recession it is the pessimists’ turn to explain why they think everything will be worse forever. Some look at trend growth over the last thirty years and decide that the economy is broken, but take a look over the last 140 years and there have been bigger divergences from trend that still snapped back. As the 14th century monk William of Occam would have argued, the simpler explanation that the world is not so different is to be preferred to equally plausible but more complicated explanations about why it has changed.