US Watch Group Economics Macro & Financial Markets Research Maritza Cabezas, +31 20 343 5618 Crossing borders: where is the QE money? 16 December 2014  After five years of low interest rates, US investors are increasingly showing more preference for relatively safe assets in their search for yield. High-rated governments and financial institutions have benefitted the most. Indeed, since the first round of asset purchases or quantitative easing (QE) in 2008, US investors have been gradually shifting to high-yield assets originating from Canada and Australia. It is even the case that there is some concentration of capital flows to bonds issued by these countries. Meanwhile, the value of US holdings in emerging markets as a share of total foreign holdings has increased recently, mainly showing a preference for higher yielding bonds, but with high credit ratings. From a sector perspective, after financial and governments, the energy sector has benefitted the most from US capital flows in this period. There has already been a correction in this sector given the sharp drop in oil prices.    US monetary easing and risk appetite That said, more than five years of accommodative monetary Now that the US economy is leading the global recovery and is policy have had an impact on US investors’ risk appetite. This preparing to shift towards monetary policy normalisation, the had important international spillover effects on asset prices discussion is centred on the implications of policy and global investment flows. Announcements associated with normalisation for countries that benefitted from the search for the Fed’s asset purchase programmes were followed by a yield and the low interest rate environment in the US. Since rapid increase in US investors’ holdings of foreign equity the financial crisis, the Fed has pursued a highly securities and foreign debt. The greatest response was accommodative monetary policy with low interest rates and recorded after the initial QE programme in 2008, but raising the asset side of the Fed’s balance sheet to over USD subsequent rounds also had an impact, albeit on a more 4.48 trillion from nearly USD 1 trillion at the end of 2008. The modest scale. Although it is difficult to determine the direct asset purchase programme was finally brought to an end in impact of QE on capital flows, US investments in the foreign October 2014 and Fed officials are now discussing the equity markets more than doubled over the past five years, conditions for a rate hike. with only 20% attributable to price increases. The strong demand for equities for some is not only attributable to QE, but US holdings of selected securities during QE also to the improvement in corporate profits that has USD billions 18000 accompanied the process. Q3 Q2 Q1 16000 Advanced economies more attractive to US investors 14000 12000 Foreign debt securities 10000 Commercial paper 8000 The geographical distribution of US cross-border investments shows that the United Kingdom is a main destination, followed by Cayman Islands, Canada, Japan and Australia. Since the Corporate bonds start of QE, the fastest growth of US investments in foreign 6000 holdings has been recorded in Canada, Australia, Ireland and 4000 Mortgage backed securities (Fed) 2000 Treasuries and agency debt (Fed) 0 Q1 2007 Q3 2009 Source: Thomson Reuters Datastream Q1 2012 Q3 2014 the Netherlands. The US investments in emerging markets as a share of total investments remain relatively low and have been somewhat volatile in the past five years. 2 Crossing borrders: where is s the QE money y? – 16 Decem mber 2014 Ad dvanced econ nomies mostt attractive to US investors s QE Q and US foreign assets % off total foreign hold dings holdings of US inv nvestors in % of GDP 80 45 Corporate e equities QE1 70 QE3 QE2 40 60 50 40 35 euro‐ euro‐ zone zone 22% 25 % 2013 2008 30 30 25 20 20 10 15 Q4 2005 0 Advanced economies Carribean financial C centers Emerging Markets Inte ernational Organisations 25 20 2 2013 15 10 5 0 EZ UK Carribean Can nada Japan S Switzerland Australia Sou urce: US Treasuryy Q4 2010 15 14 Corporat te bonds 13 12 11 10 9 8 7 6 5 Q4 2005 Q Q4 2007 Q4 2009 2 Q4 201 11 Q4 2013 So ource: Thomson Reuters R Datastream m Fro om a flow persp pective, the mo ost recent data show that Asia a has s had the stron ngest growth, with w Eastern Eu urope and Latin n ut the search fo or yield was noot the only motiivation driving Bu Am merica declining g. It should be mentioned thatt capital flows tto inv vestors. In view w of regulatoryy requirements,, there has bee en em merging marketss are somewha at understated, since the data a an n increasing pre eference for hi gh-grade relatively safe asse ets collected are base ed on residencce. This means s that emerging g that are more liquid. Where thee largest shifts have been ma ade arkets that issue ed debt securitties through forreign ma is in debt securitties. Data sugggest that investors have been sub bsidiaries in Ire eland or the Ne etherlands, for instance, i are n not sh hifting their fore eign financial seector bonds and government included in emerg ging markets. bo onds to instrum ments with high er credit rating gs. Currently US S inv vestments in cross-border coorporate bonds amount to 20% % of Mo oreover, it is important to reco ognise that porttfolio total corporate bond holdings, bbut this ratio ha as doubled since rea allocations that seem relatively small for US investors are 009. 20 larg ge from the perrspective of em merging marketts receiving cap pital flows. Eve en small change es in US holdin ngs can genera ate Moreover, if we compare c the reelationship betw ween holdings of larg ge asset pricess responses, ass was the case e during the do omestic govern nment bonds annd foreign government bondss, tap pering event in the summer off 2013. Where emerging we e see that, sinc ce QE, there haas been an inc crease in dema and ma arkets are conccerned, Malaysia, Peru and Poland posted t he for higher-yieldin ng bonds from ssovereigns. Ho oldings of stro ongest growth in terms of market capitalisattion. anadian and Australian goverrnment bonds, for instance, Ca US S investors and d their choice e of assets As mentioned, fro om a portfolio allocation a persp pective, US investors generally have a stron ng preference for f equities. A tota al of 70% of cro oss border inve estments are in n equities. The e ha ave increased significantly s sinnce the start off QE, while the be etter rated eme erging market loocal governme ent bonds have e als so increased. Demand D for high-yield sovvereigns in EM M US S is the only cou untry that holdss more foreign equities than fore eign debt. The Netherlands iss second, holdiing 46% of its fore eign investmen nts in equities. We see that th his preference er the asset pu has s increased afte urchase progra ammes, when w we USD billioon 70 00 60 00 50 00 tak ke away the pricce effect. Inve estments in fore eign equities 40 00 am mount now to 20 0% of total US investments. 30 00 20 00 Acc cording to the B BIS, there are many equity markets m in which h the e expected payo off from dividends exceeded the real yields on longer-dated h high-quality bon nds, making it more attractive e for market particip pants to extend d their search for f yield beyond d fixe ed-income marrkets. Stocks pa aying high and d stable dividen nds were seen as parrticularly attracttive and posted d large gains. 10 00 0 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Advanced economies excluding US So ource: US Treasurry Emeerging markets 3 Crossing borrders: where is s the QE money y? – 16 Decem mber 2014 US S investors ste epped up investments in hig gh-rated fina ancials and th he energy sector mplications of US policy norrmalisation Im Over the past few w years, energyy (oil and gas) and a consumerr A future hike in US U interest ratees could make other assets ousehold discretionary (autto components, hotels and ho he more attractive, making certainn sectors more vulnerable. Th durrables) sectors have benefitte ed most from US U capital flowss ata suggest tha at US investorss have been inc creasingly da afte er the two leading sectors govvernment and financials. US sh howing more prreference for reelatively safe assets a in their investors have pa articularly stepp ped up their forreign se earch for yield. We do, howevver, see some concentration c i in investments in en nergy. In 2008, investors held USD 344 billio on co ountries and in specific sectorrs, including en nergy. Indeed, in equities e and US SD 56 billion in n debt in the en nergy sector. sin nce the first rou und of asset puurchases or qu uantitative easing Investments in eq quities have alm most doubled and a debt has (Q QE), US investo ors have been gradually shifting to high-yield nea arly tripled sincce then. as ssets originating from Canadaa and Australia a. The asset allocation is already changing w with the recentt oil price collap pse. Alth hough, the ann nouncement to end the asset purchase pro ogramme in mid d-2013 led to volatility, v particu ularly in em merging marketss, foreign econ nomies that rec ceived these cap pital flows have e tried to impro ove their fundam mentals since the en. But those th hat are lagging will remain vulnerable. We thin nk that much off the normalisa ation process will w depend on how w the process iis communicated and managed. Fed officia ls hav ve said recentlyy that, in this process, p they will w take into acc count the impact on financial markets. Exac ctly how this willl ma aterialise is not yet known. A gradual g approa ach that allows US S policymakers to evaluate the e impact will lik kely be the pre eferred option. W We expect the e Fed to hike interest rates slow wly. We foreca ast the federal funds f rate to rise to 1.0% at yea ar-end 2015 an nd to 3% at yea ar-end 2016. 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