Posts published in January 2016
Negative interest rates – or “Wonderland” as we have come to call them – up to now have been a distinctly European fashion. The common currency Eurozone has them. So do non-currency zone neighbors Switzerland and Denmark. Nowhere else did they exist – until now. The Bank of Japan surprised markets on Friday with an announcement that it plans to lower its key interest rate to -1.0 percent. BoJ head Haruhiko Kuroda’s decision to “go European” reflects a country determined to battle its way out of near-deflation, but with a limited set of weapons in its policymaking arsenal. The most recent batch of headline statistics – also released yesterday and today – have little to show for all the slings and arrows of Abenomics over the past four years. Without meaningful structural reform to accompany its monetary policy, Japan will find it difficult to regenerate sustainable growth.
Three Tiers of Confusion
Japan’s new negative rate regime is somewhat confusing in its details. It appears that Japanese rates can be somewhat like Schrödinger’s cat – both positive and negative at the same time. Specifically, the negative rate does not apply to the ¥250-odd trillion of existing bank reserves. The majority of these will now be classified as “basic balance” reserves and they will continue to earn interest at the prevailing 0.1 percent rate. Then there will be a second, smaller tier of reserves that earn zero percent. Finally, the negative rates announced today will pertain only to a third tier of “policy rate balance” reserves – essentially, any excess bank reserves generated by future quantitative easing activity. The practical impact of negative rates remains unclear in terms of what volume of bank reserves might eventually fall into that third tier.
Japanese for “Jawboning”
The optics around the rate program may be less about quantifying its impact, and more about sending a signal to markets that Japan’s monetary policymakers are serious about pulling back from the deflation trap which has threatened the economy’s fortunes off and on for the past couple decades. The chart below shows headline Japanese inflation (their headline CPI measure excludes food but includes energy) over the past five years.
Prices in Japan topped out in 2014 shortly after the increase in the consumption tax in April of that year (one of the Abenomics arrows). The government has been forced to push out the expected timing on its 2 percent inflation target time and again. It is likely that Kuroda, by choosing a negative rate decision at this time rather than an expansion of the existing ¥80 trillion per year quantitative easing program, wants to demonstrate that he has more than one policy tool at his disposal. Indeed, the BoJ in its announcement today took pains to not rule out either additional QE or a further rate cut deeper into negative territory if future conditions so warrant.
That Elusive Structural Reform
All the QE and negative interest rates in the world, however, will amount to little more than a tempest in a teapot if Japan is unable to move forward more aggressively with its structural reforms – that elusive third arrow of the Abenomics program. Some efforts have been made – for example, some modest reforms to the country’s excessively coddled agricultural system. Agreeing to participate in the regional Trans-Pacific Partnership with the US and other Asia Pacific economies is also a good step. But Japan continues to suffer from structural problems decades in the making – excessive saving, low household consumption, glacial progress for women in the workplace, and a refusal to countenance sensible immigration reform prominent among them.
Japan needs a “Meiji moment”. In the Meiji era of the nineteenth century the country embarked on a spectacular national program to reinvent itself from a feudal backwater to a leading industrialized nation. It later regrouped from the destruction of the Second World War to produce the miracle economy of the 1950s – 1970s. Today the Nikkei 225 stock index, at around 17,500, remains at a level less than half its peak at the end of 1989. It will take a sustained commitment to deep structural reforms, alongside fiscal and monetary stimulus, to regain that 40,000 all-time high water mark.
As unrelentingly negative as this January has been, the prevailing sentiment appears to be weary resignation rather than panic. The typical pattern we have seen over the course of this recovery is for a sharp and swift drawdown followed by an equally swift recovery. That pattern probably drew its strength from complacency that the Fed put remained firmly in place. A kind word from Bullard here, dulcet tones from Evans there and presto! No need to focus on pesky things like earnings and free cash flow when Bernanke’s got your back.
The current climate seems driven by different considerations. The put, for all intents and purposes, is over. Would the Fed consider its options if this pullback descends into bear territory? Possibly, but in our opinion an emergency rescue could quite plausibly inject a higher dosage of fear into the market and make things worse. A more likely outcome, we believe, is that stocks will lurch both ways with higher than usual volatility – a slow burn scenario rather than a collapse-and-recover event.
A Tale of Two Pullbacks: 2015-16 vs. 2011
There are some useful insights to be drawn from a comparison between the current environment and the last US market correction, in the summer of 2011. The chart below compares the two pullback events.
The 2011 event was deeper than the present event (to date). It was also shorter. Most of the damage was done in the space of ten trading days from July 27 – August 10, during which time the index gave up 15.9 percent (see rightmost area of the chart above). Stocks then lurched sideways in a concentrated series of relief rallies and selling waves until a final spasm in early October closed out the event at minus 19.4 percent from the April 2011 peak, just shy of a bear market. During the height of the pullback in August there was genuine panic trading: the index lost more than four percent in a single trading session four times between August 4 – August 18, and there were also four relief rallies of four percent or more in the same time period.
The most interesting thing about the current pullback – or to be more precise the current stage of what is now an extended single event pullback beginning last August – is the lack of breathing space for a relief rally. As we write this on Friday morning the index futures signal a large jump at the open, which may or may not translate into a rally by the close. Sentiment has been unrelentingly negative. But – and here is where we draw the key distinction between today and 2011 – there is no panic in the streets. Sure, there have been several days of two percent or more down, and intraday volatility has been wider still. But there is a world of difference between a close of two percent down and one of four or five percent down.
For that matter, the magnitude of the event is more contained than 2011. While other equity asset classes have moved into bear territory, the S&P 500 remains in mild correction territory, 12.7 percent below the all-time high set last May. And volatility has not spiked to the same degree it did in the earlier event. The chart below shows the trading pattern of the CBOE VIX index from 2011 to the present.
VIX spikes in the current pullback have yet to reach the peaks attained in 2011. It is also interesting that volatility during the recent phase of the pullback is far short of the brief spike last August. This again points to the idea that what we have now is a slow burn of negative sentiment rather than panic. We do expect, though, that volatility is likely to stay at elevated levels relative to what it was in 2014 and the first half of 2015.
But volatility swings both ways. This observation brings us back to the point we made in the second paragraph above. Higher volatility and periodic swings up and down make a more plausible scenario for 2016 than the collapse-and-recover pullbacks of recent years. Without the Fed as a backstop the market should be driven by corporate earnings as well as X-factor events around the world. Currently we see a negative tilt to X-factor risks, but that relates only to the ones clear and present in today’s environment. “Unknown unknowns” could fan the negative flames or turn them positive. Time will tell, and the ride will probably be bumpy.
Our Annual Outlook will be published next week. Below is the executive summary.
2015 was a key transitional year in capital markets. In the US the year signified the end of an era. From 2009 through 2014 US equity markets grew at an average annual rate of 12.6 percent largely due to the efforts of the US central bank – the Federal Reserve – to stimulate markets through a combination of zero-level interest rates and outright open market purchases of fixed income securities. The Fed wound down QE (quantitative easing, the term for its bond-buying programs) in 2014. At the end of 2015 it raised interest rates for the first time since 2006, albeit very gently. With the training wheels of monetary policy stimulus coming off, US stock markets returned last year to a focus on fundamentals. For better or for worse, we expect that trend to continue in 2016.
The economic backdrop in which US equities will perform this year is little different from the trend of the past couple years. The economy is growing, albeit modestly in comparison to historical norms. We are close to what economists would consider to be “full employment”, with the strongest consecutive periods of job creation since the late 1990s. Upward movement in wages is still elusive, though it bears mentioning that wage growth did slightly outpace inflation in 2015. Consumer spending, which makes up the lion’s share of US GDP, continues to grow although there was a general sense of disappointment with the 2015 holiday season. We see little reason to believe that GDP will grow by more than three percent this year or by less than one percent. Overall, US economic fundamentals should remain favorable this year.
Elsewhere in the world the story is quite different. The European Central Bank launched an expanded monetary stimulus program early last year, extended the terms of the program yet again towards year-end, and is expected to do more again this year to lift Europe out of its economic funk. China is also contending with the realities of slowing growth and looking for ways to manage a very tricky economic rebalancing away from investment towards consumer activity. In essence, the global economy’s path is diverging, with the US on one track and the rest of the world on another. The related uncertainty suggests the potential for more volatility than we have seen in recent years.
The aforementioned China rebalancing looms large as the year gets under way. The world’s second largest economy continues to grow, if not at the double-digit levels to which it was accustomed in the previous decade. Retail sales and other measures of activity are healthy. But slowing growth is a concern for a variety of reasons. China’s non-financial debt-to-GDP ratio is approximately 250 percent. A sharp growth contraction could have a negative knock-on effect among other Asian economies. And China has the potential to roil international credit markets if it feels compelled to sell off large amounts of FX reserves (mostly US Treasuries and other sovereign debt) to prevent a currency rout.
At the same time, China’s shift away from the massive public and private investment programs which drove its earlier phase of growth has major implications that reach far beyond its own borders. In particular, the growth boom of 2000-14 drove a massive commodities supercycle. It will likely take a very long time for the energy and industrial commodities which rode the boom to approach anything close to their peak prices. In the meantime, stabilization at lower trading ranges is the most optimistic case for a wide range of commodities in 2016. Resource exporters from Brazil to Australia and Russia will feel the pain. And companies in the energy and mining sectors will continue to deal with downsizing, project cancellations and, in some cases, potential for debt defaults.
As headline-grabbing as China’s predicament is, the situation is more dire still in other emerging markets. Brazil and Russia, which alongside China and India make up the once-dynamic BRICs, are both in protracted economic and (in Brazil’s case) political crises. Other erstwhile engines of growth from Turkey to South Africa, Malaysia to Indonesia, have seen their currencies collapse by the largest amount since the 1997 Asian currency crisis. Dollar-denominated debt obligations remain a potent overhang. And with weak demand seemingly a chronic feature just about everywhere, opportunities to export one’s way out of trouble seem limited. Emerging markets as an asset class has disappointed for several years; we do not see that changing significantly this year.
How will the monetary policy divergence noted above affect interest rates in 2016? The short end of the yield curve is probably more predictable. The spread between US and Eurozone yields, with the latter firmly ensconced in negative territory, could widen further still if the Fed sticks to its plan of gradual rate hikes. The intermediate/long term is subject to other variables, not the least of which is the potential for foreign central bank sales of US Treasuries to support their beleaguered currencies. Finally, expect credit quality spreads to be a continuing story in 2016. The sorry state of resource sectors like exploration & production and mining has taken a toll on the high yield market. But spreads continue to widen as well between higher-and lower-rated investment grade securities. Tightening credit conditions could also have an effect on corporate decision-making. Stock buybacks and M&A, both of which rely heavily on debt financing, could feel the impact of more stringent credit conditions.
X-factors – our shorthand for latent risks that could turn into live threats – abound in 2016. The Middle East, never the world’s most calmest region, looks less stable than ever. Europe faces a potential humanitarian crisis as refugees continue to arrive in droves. In the US, the Presidential election reflects a sharply divided and dissatisfied populace, with the potential to throw out the playbook on the usual rules of the game. Russia’s foreign policy adventurism continues apace. These are just a few of the prominent potential threats we know; there very probably are others. Always remember, though, that X-factors can be both positive and negative. Market sentiment can change very quickly as the landscape changes.
In summary, we believe 2016 will likely be a year of trend continuation rather than mean reversion, with dominant trends like monetary policy divergence, a strong dollar, commodities prices and uncertainty about China shaping the sentiment. We expect US equity markets to be strongly influenced by earnings. Rationally, that would imply the potential for price gains in the low single digits. However, as bull markets get old – the current one is in its seventh year – rationality often gives way to volatility. Volatility can work on both the upside and the downside – melt-ups are as common as melt-downs. We believe the right response to the uncertainty of this environment is to remain diversified across a spectrum of low-correlated asset exposures, and to avoid large concentrations in any given area.
There has been almost nothing “happy” about the New Year thus far. It’s probably a good thing that investors had a whole weekend in which to shake off New Year’s Day hangovers before showing up to face a sea of red arrows on Monday morning. Those red arrows, of course, came courtesy of yet another series of bafflingly inept moves by Beijing’s financial policymakers. It would be an exaggeration to say that the world’s second largest economy is in a swoon, but its financial markets certainly are.
But while the dramatic pullback in world equity markets and rising volatility are strong reasons to give pause, we do not believe this is the right time to pull the panic switch. While unquestionably a critically important component of the global economy, China depends on other world markets for its exports more than other world markets depend on China’s domestic demand for their own fortunes. Moreover, the fortunes of US companies still depend more on the US consumer than anything else. This year may provide a decisive answer to the question of whether the US economy can continue to prosper as the world’s growth engine despite increasing weakness elsewhere. We don’t yet know that answer – but based on the data we have on hand, we are not ready to jump into the lifeboats. If today’s environment bears any resemblance to past periods, we think more of 1997-98, and less of 2007-08. It is worth revisiting what happened back then before we conclude with our thoughts on the current market.
Asian Currencies, Act I
The Asian currency crisis of 1997 had an effect on equity markets around the world, including the US. The chart below shows the price performance of the MSCI All Counties Asia Pacific index from January 1997 to December 1998, versus the S&P 500 for the same time period.
The carnage in Asia was fast and brutal, with currencies falling as much as 40 percent against the dollar, and regional stock exchanges losing as much as 60 percent. As the above chart shows the S&P 500 (in green) suffered a rapid succession of pullbacks of 5 percent or greater between the summer of 1997 and January 1998 (the pullbacks are indicated in the chart along with the magnitude of each peak-to-trough drawdown). These pullbacks came on the heels of a near-10 percent correction that took place before the currency crisis. Many investors at the time interpreted this shaky performance – in the context of a deeply troubled global economy – as presaging an end to the bull market that had run nearly uninterrupted since early 1995. Asia was seen as the world’s emerging growth region, with great promise for US companies to manufacture, source labor and materials, and sell to the fast-growing middle class households in the region. The currency crisis threatened to bring a swift end to the good times and to provide a headwind to US companies’ EPS growth.
Russia Unleashes the Bears
As dire as the currency crisis was for Asian markets, which continued to fall through most of 1998, the US channeled its inner Taylor Swift and “shook it off” to rally strongly through the first half of 1998. Investors’ focus turned away from turmoil elsewhere to focus on the strength of the domestic US market, particularly the tech boom riding on the Internet’s penetration into commerce and social life. Then another foreign time bomb went off in August, when Russia devalued its currency and defaulted on its sovereign debt obligations. Another massive selloff took place in US equities – this one approaching the 20 percent threshold for a bear market. Caught up in the Russia collapse was the hedge fund Long Term Capital Management, which over the course of a tense few days threatened to turn this pullback into a genuine pandemic.
After all the drama, though, it turned out that the best way for investors in US stocks to navigate these two volatile years was to…do nothing at all. The S&P 500 registered a 66 percent cumulative price gain from the beginning of 1997 to the end of 1998. It was undoubtedly tempting to sell out at various critical junctures, but patience and discipline were rewarded.
Asian Currencies, Act II
Asian currencies are once again at the center of things. Most fell sharply against the dollar last year, though so far by generally less than they did in 1997. The Malaysian ringgit, for example, is about 23 percent lower versus the dollar over the past twelve months, and the Thai baht is softer by some 11 percent. Of course, this time it is the China renminbi – largely not a factor in the ’97 crisis – that is the center of focus. The RMB has devalued by just over six percent from where it was before the first bout of devaluation last August. What should not be forgotten, however, is that the renminbi was largely flat against the dollar in the first half of 2015, while the euro and other developed and EM currencies were falling.
Also worth remembering is that China as well as its Asia EM neighbors are in far stronger FX reserve positions today than they were in 1997. The threat of a debt default by any regional government is considerably more remote than it was nineteen years ago. China’s policymakers may demonstrate a tin ear when it comes to considering the likely short term impact of their decisions on world financial markets, but it is hard to imagine them making the kind of policy mistake that would trigger a real economic freefall.
And that brings us to China’s real economy. All the drama this week started with a below-consensus manufacturing report representing a fifth month of contraction. At the same time, though, recent indicators of consumer activity have been good – retail sales have been growing at double-digit rates for most of the last twelve months. If China’s economic transition is going to succeed, it is going to succeed thanks to the consumer, so these trends are absolutely consequential to the larger picture.
And if China does export price deflation to other markets through a weaker currency? Well, lower prices for China imports could be stimulative for US consumer activity. As we said earlier, what is good for the US consumer will likely be good for US stocks. Admittedly, this is a rational argument being made at the end of an irrational week. We may not be out of the woods as far as the current pullback is concerned. But we are not panicking.