The Great Gatsby is far more than the portrait of a disillusioned love story between Nick Carraway, a bond salesman and his beloved Daisy Buchanan during the roaring twenties. The Great Gatsby is all about money and the illusion of money, depicted in a tale of heavy spending on the back of wild and glittering parties.
In the aftermath of the World War I, the stock market rise led to a sudden growth in wealth in an unprecedented period of prosperity and excess. Scott Fitzgerald understood that the party couldn't last forever as he depicts the disintegration of the American dream built on "easy money". There is a need to revisit the Great Gatsby as it resonates in today's struggles.
In fact, in the past 2 months, the market had a hard landing wake-up call on reality: the potential end of a 5 years period of "easy money" policy. At the last Federal Open Market Committee (FOMC) minutes, US Federal Reserve Chairman, Ben Bernanke signaled that the "easy money policy" could be reduced if the US economy recovers. A careful reading of the statement indicates that the Fed is looking to re-introduce a notion of risk into the market. The Fed is not a safety-net that is to be taken for granted: hence the stress on the fact that asset purchases will increase or decrease as appropriate with respect to the Fed's dual mandate. The prospect of a tapering in the Fed's bond purchases is a separate topic from a rise in interest rate, the latter not expected before 2015.
The market misinterpreted the Fed's statement pricing ahead of the curve an end rather than a tapering of the Quantitative Easing, and embarked into a painful and disorderly sell-off. The 10 Year US Treasuries yield was sent up by more than 1% since May 10 to 2.60%. This sudden upward pressure on yields reminded investors sore memories which refer today to the "1994 moment". 1994 was the year when a brutal shift of Fed regime to a cycle of rate hikes sent the US Treasuries to their worst return ever until 2009. In fact, in 1994, while the US economy was recovering from the big recession of the late 1980s, Alan Greenspan, the Fed Chairman surprised the market by doubling the Federal funds rate from 3 to 6% in less than a year. As a result, in 1Q 94 the bond market suffered on an aggregate level, a loss of 2.7%, close to the loss of 3% in 2Q 13, the worst quarter since 1988.
While the sharp sell-off year-to-date affected the fixed income asset class as a whole; Emerging Markets suffered the most in terms of total return given the longer duration of its bonds universe. On the equity side, year-to-date the MSCI Emerging Markets index fell by more than 14% and on the debt side the JP Morgan Emerging Markets Bond Index "EMBIG" tumbled by more than 8%. Also, High Growth Market dedicated fixed income funds experienced their worst outflows in the past 3 years.
A few steps back in time can help us understand what is happening in today's markets. Following the 2008 crisis, Quantitative Easing measures have served to stimulate the Developed markets 'economies by encouraging lending and spending. However, credit and lending growth have not been materially observed in developed nations, rather, excess liquidity has poured into Emerging Markets. There are several reasons why High Growth Markets were targeted by this excess liquidity. In a nutshell, Emerging Markets went through the 2008 crisis with low levels of debt and thus stronger balance sheet compared to Developed markets. Investment yields were also high, attracting foreign investors looking for alternatives in a low rate environment. This spill over of "easy money" has resulted in a multi-year bull trend for Emerging Markets. In fact, since September 2008, High Growth Markets debt generated a return close to 50% one of the highest among all the assets classes.
However, in the past months, hints on Quantitative Easing tapering have triggered a repatriation of liquidity to Developed markets in a panic sell-off. Fast money investors tend to flip riskier and less liquid assets first, in a "sell now and ask questions later" mode. Social and political unrest in Brazil and Turkey, 2 countries which rely on foreign flows to finance their deficits, exacerbated the disorderly sell-off. Finally, fears that China, the growth engine may miss its own 7.5% growth rate target this year as well as worries about its shadow banking system emerged again. But China is not here to save the world; it is just looking to adjust to a more sustainable consumption-driven and better-quality growth supported by a robust middle-class, rather than a growth led by fixed asset investment.
Emerging Markets had a hard time so far this year. While technicals will continue to dominate the scene for some time, it is worth noting that the creditworthiness and the structural growth story of High Growth Markets remain intact and superior to those of Developed markets, and eventually the calm will come after the storm.
Going forward, the stability is US Treasuries is crucial to restore investors' confidence in the bond market. The US Equities market offers a"safe heaven status" in this period of uncertainties. Also, near term tapering is already discounted and the Fed will be very carefully in withdrawing its "easy money" policy. Most importantly, gradualism will be key, as we enter this long period of transition. While one cannot exclude the volatility which will come along, pockets of value emerge.
Recent turbulences did not affect equally all the Emerging Markets and differentiation is essential going forward. Bonds from the Middle East have been more resilient than global peers, especially sukuk. Credit spreads of regional corporates have tightened year-to-date while credit spreads of global High Growth Markets have widened over the same period. In terms of total return performance, High Yields corporates from the Middle East posted a positive performance of +1.10% year-to-date while on average Emerging Markets assets from the same category were down by more than 3.30%. This outperformance is the result of the political stability in the region, the strong macro economic fundamentals as well as the robust local bid.
It is not a coincidence that the last adaptation of the Great Gatsby with Mia Farrow and Robert Redford was in 1974, the year of the worst stock market crash in the future G7 economies. If history is (hopefully) not repeating itself this year, we can only hope that 2013 will be remembered as the year to a smooth "Great Transition" to a new monetary policy regime.
Source: JP Morgan bonds indices.
Christiane Nasr is director and senior investment advisor for the Middle East at Credit Agricole (Suisse) S.A.
© Zawya 2013
