Posts tagged Ecb
How do you tell whether someone is a novice investor or a seasoned observer of the ways of the capital markets? Simply pose a question like the following: “Growth data show a marked slowdown in economic activity in key economic regions like China and the European Union. Good or bad for global equities?”
“Bad!” says the novice. “Low growth means a poor outlook for companies’ sales and earnings, and that should be bad for the stock price, right?”
To which the seasoned pro chortles a bit and ruefully shakes his head. “Let me tell you how the world really works, kiddo. That low growth number? That’s good news! It means the central banks are going to prime the pump again and flood the world with cheap money. Interest rates will go down, stocks will go up. Easy as ABC!”
Down Is Up
The logic of “bad news is good news” has been a constant feature of the current economic growth cycle since it began in 2009 (and, barring any surprises, will become the longest on record come July of this year). The key economic variable of this period has not been any of the usual macro headline numbers: real GDP growth, inflation or unemployment. It has been the historically unprecedented low level of interest rates.
Short term rates in the US were next to zero for much of this cycle, with persistent negative rates (a phenomenon which itself flies in the face of conventional economic theory) in Europe and Japan. Central banks argued that their unconventional policies were necessary to restore confidence in risk assets and stimulate credit creation for the benefit of consumer spending and business investment. The evidence would seem to support the bankers’ view, as growth started to creep back towards historical trend rates while labor markets firmed up in most areas. The Fed has drawn its share of criticism for the easy money policies of quantitative easing (QE) from 2009 to 2015 -- but the Bernanke-Yellen-Powell triumvirate will forever be associated with the phrase “longest economic recovery on record” when that July milestone is reached.
Draghi Speaks, Markets Balk
But to return to that conversation between our novice investor and seasoned stock pro: Does “bad news is good news” always work? Is there a point at which the magical elixir of monetary stimulus fails to counter the negative effects of a slowing economy? That is a question of particular interest this week. On Thursday, the European Central Bank (ECB) backed away from its attempt to wean markets off easy money when it reopened the Targeted Longer-Term Refinancing Operations, a stimulus program to provide cheap loans to banks, for the first time in three years. ECB chief Mario Draghi made it clear that the catalyst for this return to stimulus was the steadily worsening outlook for EU economic growth.
This time, though, markets failed to follow the “bad is good” script and reacted more the way our novice investor would think makes sense: selling off in the face of a likely persistence of economic weakness. Italy is already in recession, Germany is only barely in growth territory, and demand in the major export markets for leading EU businesses is weakening, most notably in China. That economy, the world’s second largest, has its own share of problems. A record drop in Chinese exports -- far worse than consensus expectations -- sent Chinese shares plunging overnight Thursday. Other Asian export powerhouses including South Korea and Japan are also experiencing persistent weakness in outbound activity.
Pivot to Fundamentals
In our annual outlook published back in January we noted that weakness in Europe and China was prominent among the X-factors that could throw a wrench into markets in 2019. For much of the time since then it has not seemed to be much of a factor. World equity markets bounced off their miserable December performance in a relief rally driven by the “bad is good” logic of a dovish pivot by central banks, underscored formally by the Fed in late January.
But the market’s underwhelming response to the ECB on Thursday, amid a vortex of troubled headline data points that now includes a tepid US February jobs report, suggests that real economic activity may be starting to matter again. In just a few weeks we will start to see corporate sales & earnings numbers for the first quarter, which consensus expectations suggest could be negative for the first time since 2016. Shortly after that will come Q1 real GDP growth, which analysts are figuring could be in the range of one percent. All this could suggest more of that volatility we predicted would be a primary characteristic of 2019 risk asset markets.
Our novice investor of that earlier conversation may not be schooled in the ways of markets, but she made one salient point. Low growth should mean a poor outlook for company sales and earnings. Those sales and earnings, in the long run, are all that really matters, because a share price is fundamentally nothing more and nothing less than a net present value expression of all that company’s future cash flows. Perhaps the time is at hand when this long-term truth will actually have an impact on the market’s near-term directional trends.
The current bull market in US equities, the pundits tell us, is the second-longest on record. That may sound impressive, given that domestic stock exchange records go back to the late 19th century. But it doesn’t even hold a candle to the accomplishments of the current bull market in bonds. The bond bull started in 1981, when the 10-year US Treasury yield peaked at 15.84 percent on September 30 of that year. It’s still going strong 36 years later, and it’s already one for the record books of the ages.
According to a recent staff working paper by the Bank of England, our bond bull is winning or placing in just about every key measurement category going back to the Genoese and Venetian financial economies of the European Middle Ages. Lowest risk-free benchmark rate ever – gold medal! The 10 year Treasury yield of 1.37 percent on July 5, 2016 is the lowest benchmark reference rate ever recorded (as in ever in the history of money, and people). The intensity of the current bull – measured by the compression from the highest to the lowest yield – is second only to the bond bull of 1441-81 (what, you don’t remember those crazy mid-1400s days in Renaissance Italy??). And if the bull can make it another four years it will grab the silver medal from that ’41 bull in the duration category, second only to the 1605-72 bond bull when Dutch merchant fleets ruled the waves and the bourses.
Tales from the Curve
But does our bull still have the legs, or is the tank running close to empty? That question will be on the minds of every portfolio manager starting the annual ritual of strategic asset allocation for the year ahead. Let’s first of all consider the shape of things, meaning the relative movements of intermediate/long and short term rates.
We’ve talked about this dynamic before, but the spread between the two year and ten year yields is as tight as it has been at any time since the “Greenspan conundrum” of the mid-2000s. That was the time period when the Fed raised rates (causing short term yields to trend up), while the 10-year and other intermediate/long rates stayed pat. It was a “conundrum” because the Fed expected their monetary policy actions would push up rates (albeit at varying degrees) across all maturities. As it turned out, though, the flattening/inverting yield curve meant the same thing it had meant in other environments: the onset of recession.
An investor armed with data of flattening yield curves past could reasonably be concerned about the trend today, with the 10-year bond bull intact while short term rates trend ever higher. However, it would be hard to put together any kind of compelling recession scenario for the near future given all the macro data at hand. The first reading of Q3 GDP, released this morning, comfortably exceeded expectations at 3.0 percent quarter-on-quarter (translating to a somewhat above-trend 2.3 percent year-on-year measure). Employment is healthy, consumer confidence remains perky and most measures of output (supply) and spending (demand) have been in the black for some time. Whatever the narrowing yield curve is telling us, the recession alarms are not flashing orange, let alone red.
Where Thou Goest…
So if not recession, then what? Leave aside for a moment the gentle undulations in the 10-year and focus on the robust rise in the 2-year. There’s no surprise here – the Fed has raised rates four times in the past 22 months, and short term rates have followed suit. Historically, the 2-year yield closely tracks Fed funds, as the chart below shows.
The upper end of the Fed funds target range is currently 1.25 percent, while the 2-year note currently yields 1.63 percent (as of Thursday’s close). What happens going forward depends largely on that one macro variable still tripping up the Fed in its policy deliberations: inflation. We have two more readings of the core PCE (the Fed’s key inflation gauge) before they deliberate at the December FOMC meeting. If the PCE has not moved up much from the current reading of 1.3 percent – even as GDP, employment and other variables continue trending strong – then the odds would be better than not the Fed will stay put. We would expect short term rates, at some point, to settle perhaps a bit down from current levels into renewed “lower for longer” expectations.
But there’s always the chance the Fed will raise rates anyway, simply because it wants to have a more “normalized” Fed funds environment and keep more powder dry for when the next downturn does, inevitably, happen. What then with the 10-year and the fabulous centuries-defying bond bull? There are plenty of factors out there with the potential to impact bond yields other than inflationary expectations. But as long as those expectations are muted – as they currently are – the likelihood of a sudden spike in intermediate rates remains an outlier scenario. It is not our default assumption as we look ahead to next year.
As to what kept the bond bull going for 40 years in the 1400s and for 67 years in the 17th century – well, we were not there, and there is only so much hard data one can tease out of the history books. What would keep it going for at least a little while longer today, though, would likely be a combination of benign growth in output and attendant restraint in wages and consumer prices. Until another obvious growth catalyst comes along to change this scenario, we’ll refrain from writing the obituary on the Great Bond Bull of (19)81.
In our commentary last week we made brief mention of the surprising strength of foreign currencies versus the US dollar in the year to date. This week served up yet another helping of greenback weakness, and it is worth a closer look. Perhaps the most intriguing aspect of the dollar’s stumble is how broad based it is, across national economies with very different characteristics. Consider the chart below, which shows the value of two developed market currencies (Eurozone and United Kingdom) and two emerging markets (Brazil and India) versus the dollar.
Brevity of the Trump Trade
As the above chart shows, all four currencies (and just about all others not pictured here) fell sharply against the dollar in the immediate aftermath of the US presidential election last November. Recall that asset markets broadly and quickly coalesced around the notion of a “reflation-infrastructure trade,” premised on the belief that swift implementation of deep tax cuts and a torrent of infrastructure spending would spark inflation in the US and send interest rates sharply higher. Even today, there is no shortage of lazy punditry in the financial media reflexively blurting “Trump trade” every time the stock market turns higher.
But the currency markets long ago signaled the non-existence of the reflation pony in the back yard. In most cases, the foreign currencies’ upward trajectory began late last year or in the first month of 2017. Despite some localized setbacks (e.g. the latest shoe to drop in Brazil’s ongoing political scandal back in May), that upward momentum has continued and gained strength. Even in Great Britain, the negative sentiment surrounding the woeful state of Brexit negotiations has been outweighed by even stronger negative sentiment against the dollar.
Many Stories, One Sentiment
So what is behind this singular sentiment that seems to pervade all continents and economies in various stages of growth or disarray? How long is it likely to last? One of the most popular themes, certainly for much of the summer, has been the perception of stronger growth in the Eurozone. ECB Chair Mario Draghi’s comments on the better than expected growth trend back in late June immediately catalyzed another leg up against the dollar, not just for the euro but for other, seemingly unrelated, currencies. A new consensus set in that the ECB would begin tapering its bond purchases sooner than planned, and Eurozone rates would trend up accordingly.
That’s fine as far as it goes, but there would appear to be more to the story. First of all, the Eurozone may be growing slightly faster than expected, but it is hardly going gangbusters. In fact, the real GDP growth rates of the US, Eurozone and Japan are curiously symbiotic. Inflation in all three regions remains well below the 2 percent target of their respective central banks. And then there is the curious case of the euro’s recent strength even while bond yields have once again subsided. The chart below shows the YTD performance of the euro and yields on 10-year benchmark Eurozone bonds.
The spike in intermediate bond yields that followed from Draghi’s June comments has almost completely subsided back to where it was before that. Part of this, we imagine, is due to a more muted ECB posture recently, both at the Jackson Hole summit a couple weeks ago and in comments following the bank’s policy meeting this past week. The falling yields also have to do with a slightly more cautious tone that has crept into risk asset markets as investors take stock of geopolitical disturbances and the disruptive effects of the hurricanes that continue to make headlines in the southern US and Caribbean islands.
None of this would indicate to us that going bearish on the dollar is some kind of “fat pitch” trade, there for the obvious taking. In a world of relatively low growth, the US remains an economic leader in many key sectors from technology to financial services. It would only take a couple readings of higher inflation to bring back expectations for a third rate hike by the Fed and renewed commitment to balance sheet reduction. Recoveries elsewhere in the world are likewise not immune from setbacks that could necessitate a redoubling of stimulus.
That said, national currencies do, to some degree over time, reflect general sentiment towards the prospects of the home nation. Right now, it would be fair to say that those views are mixed, and not necessarily trending in the right direction, as concerns the US. Whether that leads to further dollar weakness or not is by no means certain, but it is increasingly a trend that cannot be ignored.
Jackson Hole is, by all accounts, a lovely redoubt, high up in the Rocky Mountains of Wyoming. As has been the case every August since 1978, the monetary mandarins who set the agenda for the world’s central banks will dutifully traipse up to this hiking and skiing paradise next week for their annual economic symposium. The attention span of the global investment community will briefly train its attention on Jackson Hole, and not on account of the riveting topics on tap for keynote speeches and panel confabs. This year’s symposium title is “Fostering a Dynamic Global Economy,” an anodyne and, in this contentious day and age, somewhat wistful formulation. If nothing else, though, it at least rolls off the tongue more easily than last year’s unfortunate word salad of a lead line: “Designing Resilient Monetary Policy Frameworks for the Future.” Central banker says what?
Euron a Roll
No, investors’ interest in the proceedings will be strictly limited to whatever policy utterances may spring forth from the lips of bankers, none more so than European Central Bank chief Mario Draghi. A frisson of anticipation rippled in late June from Draghi’s musings about the stronger than expected pace of recovery in the Eurozone. These musings, not unlike Ben Bernanke’s “taper” kerfuffle of May 2013, sent bond markets and the euro into a tizzy as investors imagined the beginning of the end of Eurozone QE. The euro in particular went on a tear, as the chart below illustrates:
So much did the currency respond to fears of a more aggressive QE taper by the ECB that a strong euro has replaced a strong Eurozone as the central bank’s chief concern, as revealed by the most recent ECB minutes published this week. The euro’s strength puts regional companies at a competitive disadvantage for their exports, and complicates the ECB’s elusive target of 2 percent inflation. The characteristically cautious and incremental Draghi is thus likely to be on his guard to avoid any comments that could be interpreted by the market as hawkish policy leanings. Those tuning into the Jackson Hole proceedings may well come away with little more than the bland sentences peppered with bursts of arcane math that make up the majority of central bank speeches. More likely, investors will have to wait until the ECB’s next policy meetings in September and October for guidance on the timing of QE tapering.
The Smell of Fear
Concerns about the euro come at the same time as a smattering of long-dormant volatility comes back into risk asset markets. The CBOE VIX index has found a new home above 15 in recent days – still below the commonly accepted fear threshold of 20, but well above the sub-10 all-time lows it has plumbed for much of the past several months. Global stock indexes have experienced some attendant turbulence in the form of 1 percent-plus intraday pullbacks – fairly tame by historical norms but enough to re-ignite the chatter about the duration of this bull market, expensive valuations and all the rest.
It’s been awhile since shaky asset markets have tested central bankers’ nerves. Nor is there any clear indication that this late summer volatility will develop into anything more than a brief passing thunderstorm or two. But we have sufficient evidence from recent history that the policymakers do react to asset prices. They will likely be wary of pushing too hard for normalization policies (tapering on the part of the ECB, balance sheet reduction and further rate hikes for the Fed) if they sense that such moves will feed into already jittery capital markets.
Chances are that the only “hikes” on the agenda at Jackson Hole will be the kind involving nature’s beauty, not interest rates. We don’t expect much from Wyoming to be moving markets next week. But the central bankers still face a dilemma: how to proceed with the normalization they so want to accomplish when (a) market reactions could be troublesome, and (b) the urgency from a macroeconomic perspective is not clear and present. This will be one of the key contextual themes, we believe, heading into the fall.
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.