The Start of the End of QE. Emerging Markets and Global Bonds Tumbled

The Fed's willingness to dial back on the amount of stimulus it is pumping into the economy generated much shockwaves across financial markets. MANDEL NGAN/AFP/Getty Images

Brace for it. A wall of text is coming your way! There are so many major events in the month of June such that only a Great Wall of Text is sufficient to explain and analyze each of the single event. I will try to summarize the most important parts, but you will still need to have some patience to wade through the background and the analysis.

What is the "Tapering of QE"?

The QE is the quantitative easing program initiated by the US Federal Reserve with the objective to bring the cost of borrowing down further at the point when the Fed is unable to cut interest rates, as 0 is the lowest possible interest rates that they can set. The central bank than proceed to purchase financial assets from banks & financial institutions, boosting the amount of cash in the economy.  The chairman of US Federal Bank, Ben Bernanke announced a "tapering" of some of its QE policies by scaling back its bond purchases from $85 billion a month to $65 billion a month in the coming months. This announcement lead to a chain of events that rattled the global markets.

The Impact

The US stock market fell more than 6% since the announcement. Emerging markets fell as much as 15% thanks to the double impact of the fear of a collapse of the China banking system (Refer to next section for more details). Bond yield spiked and for the first time in many years, global bonds fell in correlation with the equity markets. Even safe haven Singapore government bond is not spared and the 5-10 years bonds lost around 3% of its value. Gold tumbled almost $200 and lost close to 15% of its value within 2 weeks, further adding to the panic selling to the already weakened gold prices. Major commodity producing economies also saw their currencies tumbled against the USD.

The China Credit Crunch

On June 6, China Everbright Bank failed to repay a $6 billion dollars loan to the Industrial Bank because of tight liquidity condition. The announcement of the US QE tapering a few days later added to the woes of the Chinese Banks as global interest rates shot up. It didn't help that several major banks such as ICBC, Bank of China, and others closed large fund transfer services in major cities. Adding to the drama, 2 major Chinese banks, ICBC and BOC announces that their ATM machines are unable to dispense cash due to "software upgrades".

Within a few days the interbank overnight rate soared from 3-4 percent to 13.44 percent as of June 20. The interbank rate has retreated to 7% a few days later as the China Central Bank reassured the world that they will ensure that the economy will get sufficient liquidity. 7% is still a relative high interbank rate and if this high rates persist, there is a possibility that smaller banks in China will fail.

ICBC ATM Conspiracy theory : “This is absolutely not caused by system upgrades, because these large banks wouldn’t be updating their systems at the same time.”
Photographer: Adam Dean/Bloomberg

Scary China

What worries me the most among all these events, is the China Credit Crunch. The presence of a huge China Shadow Banking with unknown amount of debt will potentially exacerbate the problem and lead to a potential trigger point for a Chinese Debt Crisis. After having seen two major debt crisis, the idea of another debt crisis, especially coming from China, will be very very very unpleasant.

The Portfolio

The portfolio has been largely spared from the ravage of the steep emerging market correction, thanks to a 70% allocation into US equities and bonds. However, the portfolio is unable to outperform the MSCI World index, mainly due to the inability of the Singapore bond funds to perform their appointed task of preserving the value of the principle during bad times. In my opinion, the financial market has overreacted to the Fed tapering and the stock and bond markets should recover quickly as bargain hunters start converging. I have moved 50% of our buffer cash into some of the best potential emerging markets, Turkey and Thailand and decided to maintain the last of the ammunition... Just in Case. Europe has been pretty quiet for the past few months, and I got a feeling that they are itching to start some trouble again....

The situation in China has been defused for now but I will keep an eye at any potential fallout. I may opt to minimize our exposure to the North Asian stock market and start allocating more of the portfolio into US and Europe in order to minimize unwanted "surprises" from China. This year will probably still be a good year for the equities market, but judging from the reaction what a tightening of the global money supply might bring, the road to profits, will be increasingly difficult when the US interest rates start to rise in the coming years.