Equity markets in the emerging market sphere are celebrating after the US Federal Reserve’s statement issued on July 31. The Fed’s statement, that the US economy grew at a modest than expected pace in the first half, has been taken as a sign that the Quantitative Easing ‘taper’ is nowhere in sight. They may be right but they should also pay heed to the Fed’s statement about the improving health of the US economy, and if upcoming indicators point to a recovery on expected lines then the Fed may commence a taper.
The US Federal Open Market Committee issued a statement after its meeting concluded on July 31, 2013. In June, the US Fed had created a flutter in global capital markets after it indicated that it might begin to taper QE3, or the third round of quantitative easing in which it pumps about $85 billion every month into the market by buying mortgage-backed securities and treasury bonds.
That money sloshes its way into the world’s capital markets and has played a key role in propping up stock markets in emerging market countries such as India. In June, the Fed said that it might begin cut back on these purchases as early as September, if key economic parameters that it was watching—unemployment, economic growth and inflation moved–either up or down depending on the variable—to desired levels. The Fed’s statement was not based on a whim but a perceived strengthening of the US economy that was not visible earlier.
The gainers of this liquidity waterfall—mainly equity and bond markets across the world and commodities—reacted in panic at the prospect of the liquidity binge ending overnight. Global investors, particularly exchange traded funds, began pulling out money sending equity markets and bond markets in countries such as India into a tizzy. India’s stock market fell by 8.5% in month since end-May.
Then, the Fed then tried to calm investors by assuring them that it was nowhere close to increasing interest rates, and had no immediate plans to taper QE3 either. That has had a positive effect as investors took comfort from the fact that there was still some time for a taper. Since end-June, Indian equities are up by 4.6% and would have risen even more but for the RBI’s tight money policy.
Yesterday’s statement after the Federal Open Committee Meeting was closely watched to see what stance the Fed would take. This is what the Fed’s statement said.
The parts that Indian investors wanted to hear:
- U.S. economic activity expanded at a modest pace in the first half.
- Unemployment levels remain elevated.
- Mortgage rates have risen and fiscal policy is restraining growth.
- Inflation has been running below the Fed’s longer-term objective
- The committee is continuing its purchase of securities worth $85 billion every month and expects that its actions will keep interest rates down, support mortgage markets, and continue its accommodative policy stance.
- Interest rates have been left untouched.
The parts that Indian investors should also be paying attention to:
- U.S. labour market conditions have shown further improvement in recent months
- Household spending and fixed investments by business expanded and housing sector has been strengthening.
- Longer-term inflation expectations have remained stable
- The FOMC expects that economic growth will pick up from its recent pace and the unemployment rate will gradually decline
- Downside risks to the outlook for the economy and the labour market have diminished since the fall (refers to autumn—begins in September and ends in December).
- Inflation remains well below the 2% objective of the Fed but will move back to that level in the medium term
- The committee will monitor economic and financial developments, as usual, in the coming months. It is prepared to increase or reduce the pace of purchases to ‘maintain appropriate policy accommodation as the outlook for the labour market or inflation changes’. It will also consider factors such as the cost of its purchases and the extent of progress towards its economic objectives.
Therefore…
The US Fed did not say it will begin the tapering of QE as early as September. But it did not say it won’t either.
It did appear to be saying that it has not seen very strong signs of an economic revival since its previous meeting. But that is not the same as saying it has taken its eyes off the taper.
All it may be saying is: we are watching the data and will see what it says and decide accordingly. Yesterday, for example, US GDP growth in the second quarter was still weak at 1.7%, above market expectations of 1%. Payroll data from ADP (www.adpemploymentreport.com) showed that the US has added 200,000 jobs in July, over June. Those are positive signs.
On Thursday, the US will report ISM Manufacturing data that should provide an indication of how industry performed during July. If that figure is below expectation, then it dilutes the impact of GDP and jobs data. And, then the next metric will be assessed and so on.
The Fed statement had a salutary effect on India’s stock markets, which have been falling for a week now. Other markets in Asia are up too. China’s stronger than expected economic growth numbers could be a contributing factor too.
Investors seem to be assuming that the Fed will not taper off purchases under QE in a hurry. They may be right. But the US Fed would have had some inkling of what lies in store and that’s why it may have cautioned the world that its QE tap may begin to close.
The best approach for Indian investors should be to keep a close watch on data coming out of the US market. Then, classify data points that are meeting, outperforming and underperforming targets in separate baskets. If the ones that are outperforming and meeting targets give a sense of a stronger recovery, then you can be certain that the Fed will taper. Whether it happens in September or a month or two later is a different matter. Likewise, if data points to a weaker than expected recovery, then there is a possibility that the Fed will delay its taper. But one thing is certain – the Fed appears confident that the US economy is on the mend. It is just not sure how much time it will take and whether it will be a wholesome recovery.
The Indian stock market was up in early trades on August 1 but lost ground later. Local investors have no option but to keep looking at the macroeconomic data that is coming out the US. The consensus view is that there could be portfolio outflows from the Indian market if the US economy strengthens. That can not only affect equities and bonds but also the foreign exchange market, at a time when the rupee has weakened against the dollar and the RBI is doing all it can to rein in volatility. Read about its latest monetary policy announcement here (link).