Posts tagged Ecb
It’s enough to make one sort of miss those crazy Octobers when goblins and other malevolent spirits wreak havoc on asset markets. Remember 2014? A weird flash crash in U.S. Treasury yields spooked investors already jittery about the Ebola virus making sensational front page headlines. The S&P 500 fell to just short of a technical correction in intraday trading before rebounding sharply as it became clear that there was no “there” there. A vigorous Santa rally carried the U.S. bellwether index up to a then-all time high right before the end of the year.
Mario Wins the Toss, Elects to Defer
At least that gave us something to write about. October 2016 thus far is a fine month for those who value calm and serenity, but for market scribes it is notably bereft of attention-grabbing headline events. Share trading volume this month on the New York Stock Exchange is somewhat below its average daily levels back in August. August, for heaven’s sake! It would appear that stock markets are catching the soporific vibes of the central banks they so assiduously follow, most recently the European Central Bank. On Thursday, ECB Chairman Mario Draghi summed up deliberations of the body’s governing council thus: We’ll talk again in six weeks. Ciao!
The ECB has a raft of unsolved problems, but this week was apparently not the time to provide any guidance as to their progress. Markets widely expect the bank will extend the current program of monthly €80 billion purchases beyond the current termination date of March 2017. However, the ECB’s rules on asset eligibility are at odds with the actual supply of viable paper in the market. Those rules probably will have to change in order to facilitate a meaningful extension of the program. Such change in turn will require agreement from the council’s German and other northern European hawks. Draghi’s deference to the December meeting likely stems from a lack of consensus today as to how to remedy asset eligibility rules to facilitate an extension of QE beyond March.
Earnings: Low Bar Well Cleared
Meanwhile, the third quarter earnings season is, rather predictably, serving up a nice dollop of upside surprises. With a bit more than 20 percent of S&P 500 companies reporting to date, both top-line revenues and mid-bottom line profits are mostly outperforming analysts’ expectations heading into the season. We expect that, when all is said and done, the average EPS growth number will be slightly positive as compared to the minus 2.6 percent consensus number projected a couple weeks back.
Yet, while upbeat earnings reports have helped a handful of individual names thus far, those low share volume figures and lackluster price drift for the S&P 500 overall indicate that, for the moment anyway, earnings season is not serving as much of a catalyst for a broad-based rally. Shares remain expensive by traditional valuation metrics, as we have frequently pointed out in these pages. Investors still have a more skeptical take on companies’ forward guidance projections, and headwinds including the dollar and weak foreign demand haven’t gone away. Until guidance announcements provide more evidence of a near-term future of double-digit EPS growth, a couple of quarters clearing a very low bar probably won’t do much to shake off the lethargy.
When Nothing Becomes Something
We still have six weeks to go before that next ECB conference, and even longer to wait for the white smoke to appear from the Eccles Building in Washington D.C. signifying the Fed’s next move. Six weeks is a long time for “nothing” – as reflected by sideways prices, low volatility and vanishingly thin trading – to continue. Some technical indicators including shorter term moving averages and 52-week highs vs. lows suggest some top-heaviness. While we don’t see any obvious lurking threats that could move from potential to kinetic (yes, including the U.S. election which, as we have pointed out before, is largely baked into current price levels), the current quiet does strike us as too quiet.
Often it is not one thing, but rather a random confluence of several things, which gives rise to sharp price reversals. The example we provided above of the October ’14 correction illustrates this well: a sudden data point anomaly (the Treasury yield flash crash), amidst a raft of vaguely disquieting, uncorrelated event headlines and a new wave of commodity price drawdowns, converged to trigger sell signals from trading program algorithms. More often than not, these turn out to be short-lived tempests. It’s been awhile since we had one, though.
Central banks in developed and (most) key emerging markets operate independently from their national governments. This independence is what endows monetary policymakers with the ability to act in times of economic strain while elected officials, hemmed in by unyielding partisan constraints, bicker haplessly on the sidelines. Increasingly, though, a taskmaster of an entirely different stripe has dominated the deliberations of monetary mandarins. Global asset markets were the unseen, but very much felt, presence in the room when the Fed convened this year to debate policy actions in January (China-sparked stock market correction), March (post-correction nerves) and June (Brexit). Asset sensitivity has been no less on the table for deliberations in Frankfurt, London and Tokyo.
The perceived reluctance of the Fed and other central banks to “provoke” risk asset markets into tantrums has drawn criticism from observers who see the bankers’ dependence on asset price movements as unhealthy and likely to end badly. Perhaps the most telling evidence of this phenomenon is in the chronic gap between the short to intermediate term interest rate projections of central bankers themselves and the market’s own take, from spot rates at the short end of the curve to Fed funds futures projections around upcoming FOMC outcomes. This week offered some evidence that the bankers may be trying to strike back. We’ll know more in the coming weeks about how much of this is posturing and how much is actual policy.
Super Mario Stands Pat
In the same week when the electronic form of Super Mario took the leap onto Apple’s new iPhone 7, real-life ECB chairman Mario Draghi chose, not only not to move, but not to say anything about not moving. The former was not a surprise; not many observers expected the ECB to announce an expansion of its current €80 billion per month bond purchasing program. But there was a general sense that Mr. “Whatever It Takes” might give a verbal nod in one or both of two ways: to extend the term of the current program from March to September of next year, and/or to indicate a widening of the eligible asset pool for ECB purchases. That second issue may be in any event unavoidable, given supply constraints on the amount of available debt under current eligibility rules.
Nothing in any way explicit, though, came from Draghi. Slumbering Eurozone bonds were suddenly jolted out of their summer reverie; the 10-year Bund yield is actually positive for the first time in many weeks. Flummoxed investors now wonder if the ECB’s silence portends something more profound; namely, an incipient declaration by central bankers that fiscal policymakers need to join the team, and meanwhile short-term asset prices be damned.
On Deck: Janet and Masahiro
Are bond yields overreacting to the ECB’s absence of verbal cues? It certainly would not be the first time. A less dramatic reading of Thursday’s meeting would simply be that Draghi’s stimulative inclinations haven’t changed at all, but that he still has work to do in bringing a likely reluctant Bundesbank on board with any expansion to the current framework, either for an extension or for a widening of the eligible asset pool. We imagine it likely that yields may fluctuate back and forth over the next ten days or so, driven more by tea leaves-reading than anything else. Both the Fed and the Bank of Japan meet in the first half of the week after next. We have made it clear in recent commentary that we see a vanishingly small chance that the Fed would actually raise rates in September, given the general absence of a need to do so and the charged political environment into which such a move would be made.
A string of recent musings by Fed officials, though, and most recently that of the normally dovish Eric Rosengren of the Boston Fed, has kept the Fed’s September meeting very much in the center of market chatter. Coming as it did on the heels of Draghi’s silence yesterday, asset markets are repricing expectations. In particular, Rosengren offered shades of Alan Greenspan circa 1996 with a reference to the dangers of “ebullient” asset markets in a climate of perpetually low rates. We should note, though, that while Rosengren got most of the headlines his was not the only view in circulation today; fellow FOMC voting member Dan Tarullo offered a more cautious observation, based on the same available empirical data informing our own recent opinions, that there is still enough slack in overall growth and price targets to not necessitate immediate action.
If the Fed does move on 9/21 – and we still do not think it will – we would see that as genuine evidence that a concerted declaration of independence is at hand. Our view would be bolstered further still if the currently very hard to read Masahiro Kuroda and his colleagues at the Bank of Japan signal at their meeting an intent to back off further forays into negative interest rate territory.
Fight or Flight?
More interesting still, though, would be the central bankers’ reaction to what could be a very nasty aftermath in those asset markets spurned by the bankers’ attempt at liberation from their clutches. How steely would the resolve of Janet, Mario and Masahiro be in the face of a violent spasm in equity and other asset markets? After all, it’s not like elected politicians and their fiscal policy executors are waiting in the wings, ready to swoop in with their own pragmatic solutions to our economic problems. Nor is there much evidence of the kind of robust organic economic growth that could get asset prices back on track after an initial swoon. Are central bankers really ready to cut the cord and see how markets survive in a world of diminished stimulus? All verbal (and non-verbal) Kabuki aside, we don’t imagine they will be inclined to tempt fate.
Today’s WMF is brought to you by the number 10. It’s the tenth day of the month, and it’s a day when 10-year debt is front and center on the capital markets stage. Switzerland and Japan have already crossed over into 10-year NIRP Wonderland, offering investors the curious opportunity to lock in losses for a whole decade. Now Germany is flirting at the event horizon; the yield on the 10-year Bund is just one basis point on the positive side of the line. One year ago all three benchmark yields were above zero, and Germany’s comfortably so. The chart below shows that the zero boundary, once breached, has proven difficult to cross back into normal territory.
Why do yields continue to plumb the depths? This comes down, as always, to a supply and demand question. In Europe, in particular, a big part of the problem lies on the supply side. The ECB is the big player (or, less charitably, the Greater Fool), but there are limits on its bond buying activities. Specifically, the ECB cannot purchase bond issues when their yields fall below the ECB’s own deposit rate, which is currently set at negative 40 basis points. That requirement cuts the ECB off from an increasingly large chunk of Eurozone debt; consider that the yield on German five year Bunds is now minus 0.43%. So further out the curve the ECB goes, and down come the yields.
Additionally, the ECB can purchase a maximum of one third of any individual bond issue, so it is constrained by the supply of new debt coming onto the market. Some observers estimate that the inventory of German debt for which the ECB is eligible to purchase will run out in a matter of months. If the ECB wants to continue monthly QE purchases according to its current program it will then have to consider (and persuade ornery German policymakers to agree to) changes to the current rules.
Meet the New Risks, Same as the Old Risks
Of course, technical issues of bond inventories and ECB regulations are not the only factors at play. The risk sentiment dial appears to be pointing somewhat back towards the risk-off end, if not for any particularly new set of reasons. Brexit polls continue to occupy the attention of the financial chattering class, with the vote looming in 13 days and a close result expected. Investors seem to be digesting last week’s US jobs report from a glass half-empty standpoint – slower payroll gains bad for growth, while improving wages mean higher labor costs which are bad for corporate earnings. Japan delivered up some negative headline numbers this week including an 11 percent fall in core machinery orders. Again, none of this is new (and for what it is worth, we continue to think it more likely that we will wake up on June 24 to find Britain still in the EU). But animal spirits appear to be laying low for the moment.
The Stock-Bond Tango
The recent risk-off pullback in overseas equity markets, though, is having less impact here at home. Yes, the S&P 500 is off today – but earlier in the week the benchmark index topped its previous year-to-date high and remains just a couple rally days away from last year’s all-time high. The really curious thing about this rally though – and why it is very much relevant to what is going on in global bond markets – is that recently stock prices and bond prices have moved largely in tandem. This weird tango has resulted in 10-year Treasury yields at a four-year low while stocks graze record highs. As the chart below shows, this is a highly unusual correlation.
This chart serves as a useful reminder that just because something hasn’t happened before doesn’t mean that it can’t happen. In fact, what is going on in US stocks and bonds is arguably not all that difficult to understand. Investors are in risk-off mode but are being pushed out of core Eurozone debt in a desperate search for any yield at all. US Treasury debt looks attractive compared to anything stuck on the other side of that NIRP event horizon. And that demand is largely impervious to expectations about what the Fed will or will not do. Short term Treasuries will bounce around more on Fed rumors, but the jitters will be less pronounced farther down the curve.
And stocks? There is plenty of commentary that sees a significant retreat as right around the corner. Perhaps that is true, perhaps not. Pullbacks of five or 10 percent are not uncommon and can appear out of nowhere like sandstorms in the desert. But – as we have said many times over in recent weeks – we do not see a compelling case to make for a sustained retreat into bear country. The economy does not appear headed for recession, money has to go somewhere, and negative interest rates have the continuing potential to turn bond buyers into stock buyers. If a pullback does happen over the summer, we are inclined to see it more as a buying opportunity than anything else.
After the three year bear market of 2000 to 2002, stock indexes around the world enjoyed a sustained bull cycle with broad participation across all major regions from the US to Europe, from Latin America to developed and emerging Asia. Most major markets set all-time highs in October 2007. Then came winter, and then another spring.
We broadly think of the period from the 2009 market bottom to the present as another single, uninterrupted bull market. Indeed, as measured by the standard of the S&P 500 or any other major US stock index, that moniker fits. But – unlike 2000-02 and most prior bull markets – the same cannot be said for the rest of the world. For example the MSCI Europe, All Country Asia and Emerging Markets indexes, as shown in the chart below, have all failed to recapture their October 2007 high water marks. For much of the non-US world, the post-2009 period can be divided into two periods: a recovery from the 3/09 trough into the summer of 2011; and then a listless sideways performance from then to the present. In fact, all three of these non-US indexes remain today below their post-recovery 2011 high points.
As anybody with a diversified portfolio knows, the S&P 500 has been a devilishly unforgiving benchmark for most of the last four years, the bane of many an asset allocator and active stock picker alike. Is there anything about the unusual contours of this time period that suggests what might lie in store? Is it time to anticipate mean reversion and load up on non-US assets, or is it better to hunker down for ever more years of Pax Americana? We consider three alternative scenarios below.
#1: Central Banks Rule , World Catches Up
This scenario starts with the largely uncontroversial observation that central banks have been the headline story in risk asset markets since 2009 and especially since the Fed announced its second quantitative easing program – QE2 – in 2010, following up with QE3 in fall 2012. QE2 in particular is a textbook case study in how central banks move markets; one can picture then-Fed chair Ben Bernanke simulating an all-net jump shot with a smug “that’s how it’s done.” That year started off poorly for US stocks, with lots of volatility and a handful of pullbacks of 5 percent or more throughout the spring and summer. In August the Fed hinted that it was considering a second QE program, after QE1 ran out in June. That was all markets needed hear to stage a robust second-half rally (the formal QE2 announcement only came in November). QE2 firmly established the playbook for the Bernanke put: more liquidity from the Fed whenever markets run into trouble. Thus there was no great amount of surprise when QE3 played out in almost exactly the same way, in fall 2012, guiding markets over the so-called “fiscal cliff” and safely into the solid double-digit returns of the next two years.
Other central bankers came later to the stimulus party, but almost all eventually showed up at the punch bowl. The “world catches up” scenario posits that non-US markets will benefit from being in the springtime of their policy stimulus programs while the US settles into autumn. Even with a more dovish Fed stance on the cadence of rate hikes this year, policy divergence is still very much a reality. The key question is whether central bank stimulus today packs the same punch as it did in 2010 and 2012. If not, we may be looking at a second scenario.
#2: Central Banks Wane, World Swoons
It would be fair to say that market reaction to monetary stimulus policies this year has been all over the place, and perhaps nowhere more so than in Japan. When the Bank of Japan moved into negative interest rate territory last month there was a very brief moment when everything went according to plan: stocks up, domestic currency down. That reversed quickly, though. In the week following the BoJ announcement the Nikkei 225 plunged and the yen soared. The currency has set successive twelve month highs against the dollar since the policy decision was announced. Over in Europe, ECB showman Mario Draghi had somewhat better luck with the markets when he announced that the ECB would essentially pay banks to make loans through a loosening of terms for the existing long term refinancing operations (LTRO) policy.
But the ECB’s move raises the expectations bar. If cheap LTRO winds up not making much of a dent in real economic activity in Europe it will reinforce a growing belief among investors that central bank stimulus amounts to not much more than a temporary reprieve for risk asset markets. The Fed is in the crosshairs on this point as well. Much editorial chatter has been expended this week on the apparent divisions among FOMC members about the appropriate pace of rate decisions this year. If the market’s collective consciousness wraps itself around the idea that central bank puts have slipped out of the money, it will then be forced – heaven forbid – to take stock of growth and earnings prospects in the real economy. That could lead Mr. Market straight to the fainting couch. Or, alternatively, things could start looking up for growth and profits, producing a third possible scenario.
#3: Valuation Matters Again
The US economy is doing okay – not great, but okay. China has not (yet) lived down to fears of a hard landing in its economic transition. Europe is staying out of recession while some Eurozone economies such as Spain are doing quite alright, thank you very much. Brazil remains a basket case, but its neighbor Argentina is coming back into the mix after a long winter. India continues to grow nicely. Commodities markets are recovering. It is not out of the question that the world economy could emerge as a more pleasant place for companies to ply their trade. If this happens, we would expect a closer focus on valuation levels that in turn could favor bargain-hunting in those world markets that have underperformed the S&P 500 in recent years. This would be especially true if a strong dollar continues to be the major revenue and profits headwind for US companies (though we should note that the dollar has lost some of its force as of late, particularly against the yen and the Aussie dollar).
Of course, it is just as plausible that none of these scenarios will come to pass. Associating cause with effect is never easy in financial markets, and this year has been particularly problematic for the professional soothsayers of our industry. The fact is, though, that in a global economy it is unlikely that the asset performance of one country will dominate the landscape forever, even if that country is the largest and most influential. Sooner or later, those geographically diversified portfolios will likely have their day. Some advance preparation may not be a bad idea.
In a fundamental sense, not a whole lot has changed for the global economy since the beginning of the year. Economic growth remains below trend just about everywhere, hindered by the well-known headwinds of weak demand, stagnant wage growth and supply-demand imbalances among others. US companies continue to experience earnings headwinds from a strong dollar. X-factors abound, from capital outflows in China to the refugee crisis in Europe and the unusually volatile political climate in the US.
When we surveyed this landscape back in early January we could see a plausible case to make for a continuation of the kind of quality rally that had characterized a good bit of the second half of 2015. Sales growth a challenge? Opt for the companies with a demonstrated model for growing the top line by double digits despite the headwinds. Productivity not what it used to be? Focus on those enterprises able to sustain strong operating profit margins.
Nice idea in theory. In practice, not so much. We are indeed experiencing a rally in global equities now, after the rocky start to the year. But a quality rally it is not. Perhaps our January outlook will be vindicated before the end of the year, but for now the market appears reactive to anything other than fundamental quality measures.
A glance at some key performance metrics for S&P 500 constituents bears testament to the seeming disregard for quality. The top ten percent of companies in the index, ranked by total stock price return for the year to date, showed average revenue growth for the last twelve months of minus 4.2 percent. By contrast sales growth for the bottom ten percent – i.e. the companies with the lowest total stock price return for the year to date – was a positive 2.3 percent for the last twelve months. Same goes for EBIT (earnings before interest & taxes): this year’s outperformers grew by negative 4.8 percent compared to a positive 3.0 percent for the dogs of 2016.
But markets are forward looking, right? Maybe investors are more interested in next twelve months’ growth prospects than in last twelve months. Then again, maybe not. The consensus estimate for next twelve months EPS (earnings per share) growth for that top decile cohort is 4.7 percent. For the bottom decile the consensus outlook is more than twice that, at 10.7 percent. And that bottom contingent is also less leveraged, with a debt-to-total capital burden of 47 percent versus 53 percent for the top decile.
Super Mario’s Bright New Shiny Objects
If investors are not paying any attention to fundamentals, it’s a pretty good bet that what they are focused on rhymes with “ventral tanks”. By all accounts the central bank in question this week is Mario Draghi’s European Central Bank. The ECB made headlines on Thursday when it announced a raft of new stimulus measures, including some genuine novelties. The market expected the deposit rate cut to minus 0.4 percent. Rather less expected, though, was an easing of the terms by which the ECB provides liquidity to banks through long-term refinancing operations (LTRFOs). Essentially, Draghi & Co. will pay banks to make loans through rates as low as minus 0.4 percent on LTRFO facilities. Other goodies in the ECB swag bag included an expansion of monthly QE purchases from €70 billion to €80 billon, and a broadening of QE-eligible instruments to include corporate debt. Draghi seemed to be at pains to emphasize his goal to see this round of stimulus actually work its way into the real economy through a higher level of credit creation.
Market reaction was predictably all over the place. The euro plunged within microseconds of the ECB announcement on Thursday morning, then turned around and rallied hard, finishing up more than two percent against the dollar. Likewise for equity markets, which condensed a “best of times/worst of times” sentiment into a single day of trading. After sleeping on it, Mr. Market seemed to like what he saw, and European bourses chugged ahead with gains of mostly two percent or more on Friday trading.
There and Back Again
That kind of intraday volatility is characteristic of an environment entirely at the mercy of central bank announcements and other macro events. It is what keeps our own sentiment in check and wary of reading too much into any directional trends. There are plenty more central bank moments on tap this year, starting with the Fed next week. How will Janet Yellen and her colleagues explain their thinking about the appropriate trajectory for rate policy here at home? The policy divergence theme – with the Fed going one way and the rest of the world going another – is back on center stage. We don’t expect the Fed to move next week, though it is worth noting that the February inflation numbers will be released just as discussions are getting underway on the second day of the event. If the recent string of upbeat numbers continues, there will be some tough decisions ahead for the FOMC.
Unfortunately, the takeaway from all this is that expectations for markets to wean themselves off central bank dependence were premature. We’ve reverted back there after an oh-so-brief flirtation last year with free cash flows and return on invested capital and the like. If this rally continues, though, at some point someone is likely to look up and notice that, gasp, valuations are really stretched. The results may not be pretty. In the end, fundamentals do matter.