QE3 Briefing
The Federal Reserve launched its mini-QE with an expiry date conditional on a labour-market improvement. This conditional expiry date is a major change from the previous QE announcements. This is a clear sign that the FOMC is comfortable with the inflation risks posed by its action and is frustrated with the slow decline in the jobless rate. The Fed will buy USD40bn of mortgage-backed securities (MBS) in addition to the USD45bn worth of US Treasuries (USTs) being bought under Operation Twist every month between now and the year-end. The lack of a specific expiry date is a dovish departure from the previous rounds of QE in our view.
The near-term impact on (Emerging Market) equity is expected to come from (1) increased fund flows and (2) reduced risk premia. Over the longer term, the probable reduction in US mortgage rates will potentially help the housing-sector recovery and consumption of imported goods.
The Federal Reserve launched its mini-QE with an expiry date conditional on a labour-market improvement. This conditional expiry date is a major change from the previous QE announcements. This is a clear sign that the FOMC is comfortable with the inflation risks posed by its action and is frustrated with the slow decline in the jobless rate. The Fed will buy USD40bn of mortgage-backed securities (MBS) in addition to the USD45bn worth of US Treasuries (USTs) being bought under Operation Twist every month between now and the year-end. The lack of a specific expiry date is a dovish departure from the previous rounds of QE in our view.
The near-term impact on (Emerging Market) equity is expected to come from (1) increased fund flows and (2) reduced risk premia. Over the longer term, the probable reduction in US mortgage rates will potentially help the housing-sector recovery and consumption of imported goods.
Portfolio flows to favour equities
According to SCB FX team‟s latest forecast, the implied value of the DXY is 81.35 by year-end, compared to 79.4 currently. This implies portfolio inflows of USD7bn in 4Q12 and full-year inflows of USD26bn. While solid, this is lower than the USD76bn and USD88bn witnessed in 2009 and 2010, respectively, reflecting lower DXY values in prior periods of QE. In our view, the impact of these inflows will be a reflation of asset values, focussed on equity markets, underpinned by 3 factors:
(1) policy makers are already making pre-emptive moves to control property values: the Hong Kong Monetary Authority (HKMA) lowered the loan-to-value ratio for second mortgages to 30% on 14 September;
(2) valuations are near cyclical lows for equities, in stark contrast to stretched housing affordability ratios across key cities in Asia;
(3) relative to bonds, Asian equities are priced at attractive levels in most markets in the region.
Emerging market is expected to outperform developed market in the near term as investors move up the beta curve. Inflation is a risk to Asia in the medium term, but regional inflation averages 3.8% today, versus 5.3% at the start of QE2. The weak state of global business today relative to late 2010 also suggests that it is too early to worry about inflation.
From a market perspective, Korea, Taiwan and Hong Kong have tended to see the strongest average performance in the three months following large-scale central bank liquidity injections. We believe this is partly because of their higher cyclical sector weightings compared to regional peers (76%, 76% and 59%, respectively). For the purpose of this analysis, we have included domestic cyclical – from consumer discretionary and real estate – sectors, along with our usual cyclical definition, which captures the industrials, materials and IT sectors.
Same markets may be favoured in near term, although higher valuations in Korea and Taiwan suggest that their gains may be short-lived, especially given the lack of any immediately apparent fundamental impact on corporate profitability. Beyond the near-term euphoria surrounding QE3, we believe investors will quickly refocus on Asia‟s economic recovery, which is likely to be led by China and India given the two countries‟ domestic drivers of investment plans and economic reforms. (Korea and Taiwan are likely to be second-order beneficiaries as suppliers to China in the tech and auto supply chain.)
According to SCB FX team‟s latest forecast, the implied value of the DXY is 81.35 by year-end, compared to 79.4 currently. This implies portfolio inflows of USD7bn in 4Q12 and full-year inflows of USD26bn. While solid, this is lower than the USD76bn and USD88bn witnessed in 2009 and 2010, respectively, reflecting lower DXY values in prior periods of QE. In our view, the impact of these inflows will be a reflation of asset values, focussed on equity markets, underpinned by 3 factors:
(1) policy makers are already making pre-emptive moves to control property values: the Hong Kong Monetary Authority (HKMA) lowered the loan-to-value ratio for second mortgages to 30% on 14 September;
(2) valuations are near cyclical lows for equities, in stark contrast to stretched housing affordability ratios across key cities in Asia;
(3) relative to bonds, Asian equities are priced at attractive levels in most markets in the region.
Moderate reduction in equity risk expected
On earnings risk premium (ERP), previous rounds of QE and LTRO have led to improvements in risk appetite. The most notable changed occurred after the Fed expanded QE1 in March 2009 by announcing the purchase of an additional USD750bn of MBS and up to USD300bn of long-term Treasury securities. The greatest impact of this was felt in China, Korea, Thailand and Indonesia, where ERP fell by approximately 3.5ppt over the period. However, it is arguably difficult to distinguish the effects of China‟s large infrastructure stimulus programme from those of QE1. Under QE2, the impact on ERP was between 0.5-1.2ppt across Asia. ERP bottomed out soon after QE2 ended in June 2011, increasing sharply in August 2011 as markets began to worry about the spread of the Euro-zone crisis. At the depth of the crisis, the ECB announced the LTRO financing facility, causing ERP in the region to drop by 0.2-1.0ppt. We expect the impact of QE3 on risk premia in AxJ to be closer to QE2 and LTRO given the absence of large-scale fiscal stimulus in the region. Financial markets have also been anticipating QE3 for a number of months, and ERP had already trended down by 0.2-0.6ppt across the region between the start of 3Q 2012 and the announcement date.
On earnings risk premium (ERP), previous rounds of QE and LTRO have led to improvements in risk appetite. The most notable changed occurred after the Fed expanded QE1 in March 2009 by announcing the purchase of an additional USD750bn of MBS and up to USD300bn of long-term Treasury securities. The greatest impact of this was felt in China, Korea, Thailand and Indonesia, where ERP fell by approximately 3.5ppt over the period. However, it is arguably difficult to distinguish the effects of China‟s large infrastructure stimulus programme from those of QE1. Under QE2, the impact on ERP was between 0.5-1.2ppt across Asia. ERP bottomed out soon after QE2 ended in June 2011, increasing sharply in August 2011 as markets began to worry about the spread of the Euro-zone crisis. At the depth of the crisis, the ECB announced the LTRO financing facility, causing ERP in the region to drop by 0.2-1.0ppt. We expect the impact of QE3 on risk premia in AxJ to be closer to QE2 and LTRO given the absence of large-scale fiscal stimulus in the region. Financial markets have also been anticipating QE3 for a number of months, and ERP had already trended down by 0.2-0.6ppt across the region between the start of 3Q 2012 and the announcement date.
Equity-market impact
While the bullish knee-jerk response to QE3 has faded, we believe equity markets have yet to fully discount the effects of the programme. Reduced tail risk in peripheral Europe, underwritten by the ECB‟s OMT, is also an important step towards providing a floor to investor confidence. However, we are observing that investors are showing greater cynicism and hesitance to embrace risk given the high frequency of central bank actions. We recommend that investors move up the beta curve but focus on quality and valuation rather than on high cyclicality alone.
Under QE3, the Fed will make monthly purchases of USD40bn from the MBS markets for a
period of time that is conditional on an improvement in the labour market. While the Fed did not
quantify the degree of improvement required, most believe the programme is
likely to remain in place well into 2013. This suggests that the fund flow impact on equity markets would be
supported in the medium term. While we agree that the impact of QE will be nowhere as large as
that experienced in 2009 (when China‟s Rmb4tn stimulus package also provided support), the
backdrop of improving earnings outlook (based on our ERI analysis), the rising pipeline of
investments in Asia and the liquidity spill over from DM will be positive for EM equities.While the bullish knee-jerk response to QE3 has faded, we believe equity markets have yet to fully discount the effects of the programme. Reduced tail risk in peripheral Europe, underwritten by the ECB‟s OMT, is also an important step towards providing a floor to investor confidence. However, we are observing that investors are showing greater cynicism and hesitance to embrace risk given the high frequency of central bank actions. We recommend that investors move up the beta curve but focus on quality and valuation rather than on high cyclicality alone.
Emerging market is expected to outperform developed market in the near term as investors move up the beta curve. Inflation is a risk to Asia in the medium term, but regional inflation averages 3.8% today, versus 5.3% at the start of QE2. The weak state of global business today relative to late 2010 also suggests that it is too early to worry about inflation.
From a market perspective, Korea, Taiwan and Hong Kong have tended to see the strongest average performance in the three months following large-scale central bank liquidity injections. We believe this is partly because of their higher cyclical sector weightings compared to regional peers (76%, 76% and 59%, respectively). For the purpose of this analysis, we have included domestic cyclical – from consumer discretionary and real estate – sectors, along with our usual cyclical definition, which captures the industrials, materials and IT sectors.
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| Observable drivers for cyclical sectors |
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| Asia's Inflation Summary of post-QE macro conditions |
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