Welcome back to December! Remember when the financial markets thought the Federal Reserve was going to raise interest rates three times or maybe even four times in 2016 and suddenly bank stocks were the thing to own? (At least until January when the Fed pulled back from its three or four times language and the market decided that one or none was more like it for interest rate increases in 2016 and sent the sector into a dumpster.)
Well, the positioning was back today–even if just for a day. After last week’s minutes from the April meeting of the Federal Reserve and after jawboning by half the Fed board of governors (it seems), financial markets have decided that a June interest rate increase could be back on the table–odds are now up to 36% from 4% before the release of the Fed minutes–and if not June then quite likely July–odds for a July increase climbed to 54% today.
That was more than enough to help the Standard & Poor’s 500 stock index to a gain of 1.4% as the index tacked on 28.02 points to hit 2076.06, comfortably, again, above the 2050 level that triggers worry that the S&P 500 is going to break through the bottom of its recent trading range.
The way upward was led by, you guessed it, banks as the SPDR S&P Bank ETF (KBE) climbed 1.86% led by stocks such as Morgan Stanley (MS) up 2.16%, JPMorgan Chase (JPM) up 1.7%, Bank of America (BAC), up 1.45%, and Capital One Financial (COF), up 1.37%. (Capital One is a member of my Jubak Picks Portfolio.)
The logic here is that bank earnings will climb if the Federal Reserve raises interest rates since that would increase the interest rate that banks can charge on their loans.
Of course, the growing conviction that the Fed will raise interest rates sooner rather than later (just two weeks ago you had to go out to February 2017 (and not July 2016) to find a Fed meeting that got better than 50% odds for an interest rate increase) took its toll on other sectors today. Gold fell another 1.8% to $1232 an ounce to set its longest losing streak since November. The dollar held near its recent two-month high against the euro.
There’s been precious little staying power to any market trend recently and today’s love affair with banks may prove to be short-lived as well. At an investor day event today Wells Fargo (WFC) lowered its projections for its 2016 return on assets to 1.1% to 1.4% from the 1.3% to 1.6% it projected at its 2014 investor day. For the full 2016 year the bank is now looking for a return on equity of 11% to 14%, down from 12% to 15%.
The big culprit is the bank’s large portfolio of energy loans and the company told investors it was taking steps to reduce the size of its portfolio of those loans. Wells Fargo said it had cut credit lines on 68% of the energy companies it had reviewed.
But it’s what the bank said about its net interest margin that might have the most impact on a continued bank stock rally. Because Wells Fargo, like many banks, has moved to reduce risk in its portfolio, it now expects that a 100 basis point upward shift in the yield curve after a Federal Reserve interest rate increase would add 5 to 15 basis points to its net interest margin. Previously the bank had estimated that a 100 basis point shift in the yield curve would add 10 to 30 basis points to its net interest margin. (100 basis points equal one percentage point.)
Step aside global central banks.It’s time for the pattern called risk-on/risk off to set the direction of global financial markets again.
In my book on volatility, Juggling with Knives, I’ve included an entire chapter on correlations between assets and markets. In an Age of Volatility I argue, correlations among asset classes can change over night and the trend that once drove markets–stocks rise with a stronger dollar, for example–can breakdown so quickly that it throws an entire investment strategy into chaos. (Buy Juggling with Knives at Amazon http://www.amazon.com/Juggling-Knives-Investing-Coming-Volatility/dp/1610394801?ie=UTF8&qid=1463761996&ref_=tmm_hrd_title_0&sr=1-1. )
Well, that’s where we are today now that markets have decided that programs of quantitative easing from central banks–the Federal Reserve, the Bank of Japan, and the European Central Bank–aren’t enough to drive economies or financial markets.
The new pattern is an old pattern, one known as risk-on/risk off.
Yes, the glorious (sarcasm alert) days when money sloshed from one asset class to another as investors decided that the markets felt risk and that this asset felt more or less risky than that asset are back.
The evidence in correlations between asset classes over the last 120 days, compiled by Bloomberg, is rather compelling.
For example, the correlation between an index of 20 emerging-market currencies and global stocks has climbed back to 0.6 to approach its level on April 8. That was the strongest correlation since December 2013. In other words emerging market currencies are moving in lockstep with global stocks. The correlation between commodities climbed to an almost six-year high of 0.7 this month. In late 2014, neither asset had a significant correlation with emerging-market currencies.
Or to take another example, the correlation between the dollar-yen exchange rate and stocks reached 0.7 in February. That was the strongest correlation since Bloomberg began collecting this data in 1987. Since then the correlation has fallen to 0.5. So, yes, while the yen still tends to weaken when equities rally, the move is a bit less strong than earlier in the year.
Why the shift back to a risk-on/risk-off market? Worries over the Brexit referendum next month on United Kingdom membership in the European Union, the chaos that is the U.S. election, a potential June or July interet rate increase from the Fed, the big sell-off in stocks earlier in 2016.
Why is this important? Because the shift in correlations should result in a rethink of some old strategies and consideration of some new possibilities. For example, the new correlations suggest taking a look at going long the Mexican peso, one of the worst performing currencies in 2016, with an increase in commodity (especially oil) prices.
Earlier today I posted that the more dovish than expected news from the Federal Reserve on Wednesday, March 16–a signal that the Fed was looking at two interest rate increases in 2016 rather than the four it had projected in December–had, in the shorter run, set off a rally in those asset classes that benefit from a weaker dollar–commodities including oil and gold, for example, and emerging market debt and equities. Today that trend remained in effect although, this being a Friday after a good run to the upside, pre-weekend selling has taken some of the strength out of that rally. As of 1 p.m. New York time the Dow Jones Industrial Average was up 0.5% and the Standard & Poor’s 500 stock index was ahead 0.49%. In the oil markets West Texas Intermediate was holding even and Brent benchmark crude was up 0.6%. Emerging market stocks, as measured by the iShares MSCI Emerging Markets ETF (EEM), were higher by 0.78%.
However, in the longer run, I noted, the global economy is still looking at a tightening of the supply of dollars. The Federal Reserve, after all, didn’t say it was about to cut interest rates or that it had decided not to raise rates at all in 2016. It announced that it would move more slowly–but that it still intended to raise interest rates. That means that a sluggish global economy is still looking at the Federal Reserve to tighten the supply of dollars–and thus to make them more expensive–in 2016, probably beginning at the Fed’s June 16 meeting. The Fed’s caution on raising rates is a reminder that the world economy runs on dollars and that the Fed, the central bank for the United States, recognizes that because of the dollar’s role as the dominant global currency it is the central bank for the world too. As much as the strength of the U.S. economy might argue for interest rate increases, the weakness of the global economy, the Fed said on Wednesday (actually fairly clearly for the Fed) isn’t ready for higher U.S. interest rates. A hike in interest rates and a stronger dollar would amount to a tightening of monetary policy for the world–and the world economy, in the Fed’s estimation, isn’t strong enough for that.
In the longer run then, the Fed’s move yesterday isn’t a big plus for all the asset classes that are up today and were up even more yesterday. The Fed’s worry about the effects of a U.S. interest rate increase should remind us that the stronger dollar that is likely to follow on such a move (all things being equal, which, of course, they never are) will act, at a minimum, to depress the prices of commodities denominated in dollars such as oil, copper, and gold.
But that effect isn’t the big worry in the current global economy. During the days when interest rates on the dollar ranged from 0% to 0.25% companies in developing economies borrowed in dollars to meet working capital requirements, to build factories, and to expand marketing efforts. In Brazil, for example, borrowing in overseas markets by non-finance companies reached a record $137 billion in 2014, the Bank for International Settlements reported in September 2015. That’s a 10-fold increase in the last decade.
Brazilian companies have been alone in this trend. In 2014 Indian companies borrowed $20 billion overseas, bringing total outstanding overseas borrowing to $200 billion. Much of that, an estimated 50%, is unhedged and rises or falls in value with the Indian rupee. That $100 billion in unhedged overseas corporate borrowing is equal to roughly 5% of India’s GDP.
In China unhedged overseas corporate debt came to $1 trillion at the end of 2014, UBS estimates. That’s equal to roughly 10% of China’s GDP.
This unhedged debt burden gets really heavy when the local currency plunges against the dollar. The Brazilian real fell 32.9% against the U.S. dollar in 2015, making every dollar of corporate debt roughly one-third more expensive to pay back. Other big currency drops in 2015 hit the Argentine peso (34.6%), the South African rand (25%), the Turkish lira (20%) and the Russian ruble (17%).
The corporate sector isn’t the only part of developing country economies exposed to the effects of high U.S. interest rates and a stronger dollar. Any country running a current account deficit and thus dependent on external cash flows to balance its accounts also feels the effect. A Brazil, a Turkey, or an India, for example, needs to attract overseas capital–and that gets harder when the local currency is tumbling and when local interest rates lag those in the United States.
Some developing country central banks tend to fight this problem by raising their own interest rates, a study by the Dallas Federal Reserve Bank, found. Mexico’s central bank raised its benchmark interest rate 0.25 percentage points on December 17, following hard on the heels of the Fed’s December 16 0.25 percentage point increase. Raising domestic interest rates does work to defend the local currency, the Mexican peso in this case, but higher domestic interest rates do take a bite out of domestic economic growth. Central banks are most likely to raise interest rates–and take the potential punishment to the domestic economy–if their national economy is dependent on overseas cash flows to balance the current account. The list of countries likely to take that uncomfortable deal, according to the Dallas Fed, includes Turkey, South Africa, Peru, Mexico Colombia, Brazil, Chile and India. I’d note that this list uses data from 2014. I think if you factor in the collapse in oil prices, Russia and Nigeria would be members of this group.
All this means, of course, that any move by the U.S. Federal Reserve to raise U.S. interest rates comes with a built in multiplier that increases the slowdown to global growth (from any slowdown in U.S. domestic growth) because of the potential drag from these coincident developing economy interest rate increases.
The other multiplier here operates through the mechanism of sovereign debt and national credit ratings–and it’s here that we pick up another big effect from the global slowdown in economic growth. The slowdown in the global economy has brought especially big drops in economic growth for developing economies dependent on demand from China and/or global commodity prices. A country such as Brazil, which had clawed its way to its first ever investment grade credit rating during the boom years has seen itself plunge back to a below investment grade credit rating. Countries that have to compete in the global markets to raise money to fund their government operations then have to pay more when their debt is graded as “more risky” and when investors have a choice of buying higher yielding and safer U.S. debt. (Safety, or perceived safety, goes a long way in the debt markets these days–how else explain the propensity of the currency and bonds of the heavily indebted (understatement alert) Japanese government to climb when investors and traders think global financial markets have turned riskier.)
None of these longer-term drags on emerging financial markets and their economies went away with the Fed’s dovish surprise on Wednesday, March 16. Their effects may have been postponed. And the drags may have decreased in magnitude with the decision, at the moment, to move to two increases in 2016 from four.
What’s difficult to calculate right now is what degree of drag was already accurately priced into crushed prices in emerging markets–in which case the explosive rally of the last two days is fundamentally justified. On the other hand, there’s the strong possibility that fundamentals have nothing to do with this rally and that it is all based on speculation and momentum.
In the last month or so as emerging market asset prices plunged, I’ve heard more and more talk of the drop in those prices setting up the trade of the decade. I’m not discounting the potential truthiness of that talk. But I sure would like to figure out whether we have one more plunge ahead as the fundamentals of the Fed’s interest rates bite home or if now is the time to buy into these assets (and as a trade or as an investment?) And I’d like to figure out which emerging markets carry the most and lease risk (and of what sort) so I can figure out what I might want to own or not.
I’ll take a stab at answering some of those questions in a post tomorrow, Saturday, March 19.
In the short-run (however, long that might be) financial markets have decided to jump on the “dovish Federal Reserve” band wagon.
Thursday, the dollar was down again and (as of 2 p.m. New York time) showed its biggest two day loss since 2009. The euro had climbed to $1.1320 today from a close of $1.1224 Tuesday.
Everything that normally goes up with a weak dollar was up. The West Texas Intermediate crude benchmark climbed to near $40 and was up 3.77% as of 2 p.m. Emerging market stocks had climbed by 2.2% (as measured by the iShares MSCI Emerging Markets ETF (EEM) as of 2 p.m. in New York on Thursday. As if to demonstrate how in favor the riskiest assets are Brazil’s Sao Paulo market was ahead 5.97% for the day as of 2 p.m.
In the short-term this all makes sense. The Fed’s decision to leave interest rates unchanged at Wednesday’s meeting of its Open Market Committee and its signal of its intention to raise interest rates just twice in 2016 instead of the four times it planned back in December does promise the world that the Fed will raise rates very, very gradually and that the Fed will remain in the easy money camp along with the Bank of Japan, the European Central Bank, and the People’s Bank of China for longer than financial markets anticipated back in December. And I suspect that there’s a very sizable group of traders that believes the Fed will pull back even from its plan for two interest rate increases in 2016.
Easy money from the Fed means a weaker dollar means rising prices for commodities priced in dollars, means substantial relief for companies in developing countries with large amounts of dollar-denominated debt and means welcome help for central banks in those economies trying to walk the line between raising interest rates to defend their own currencies and risking an even greater slowdown in economic growth from those higher interest rates.
In the short-term a Fed that is moving more slowly toward raising rates is a big plus for all these asset classes. And that’s reflected in market action of the last two days.
In the longer run (however shortly that might arrive), the Fed’s caution on raising rates is a reminder that the world economy runs on dollars and that the Fed, the central bank for the United States, recognizes that because of the dollar’s role as the dominant global currency it is the central bank for the world too. As much as the strength of the U.S. economy might argue for interest rate increases, the weakness of the global economy, the Fed said yesterday (actually fairly clearly for the Fed) isn’t ready for higher U.S. interest rates. A hike in interest rates and a stronger dollar would amount to a tightening of monetary policy for the world–and the world economy, in the Fed’s estimation, isn’t strong enough for that.
In the longer run then, the Fed’s move Wednesday isn’t a big plus for all the asset classes that are up in the last two days. Instead it’s a signal of how vulnerable these asset classes are to any increase in the strength of the dollar and any increase in U.S. interest rates. The only reason not to be worried, in the longer run, about the Fed’s move Wednesday, is if you believe the Fed will, because of global economic weakness, decide to put off even the two interest rate increases it signaled for 2016 yesterday.
But that’s another perspective and another blog post. The next one up, in fact.
The longer the financial markets thought about the actions announced by the European Central Bank today, the less impressed markets were. The STOXX 600 Europe Index had climbed as much as 2.5% during the day, but after peaking around 1 p.m., the index finished down 1.7% for the day. The French CAC 40 ended lower by 1.7% and the German DAX was off by 2.3% at the close.
The problem was that European Central Bank President Mario Draghi undercut, as far as the market was concerned, more forceful than expected action with his comments to reporters. The bank announced another 10 basis point cut to its overnight deposit rate to a negative 0.4% (as expected); raised the amount of assets it aims to buy each month to 80 billion euros from 60 billion (10 billion more than expected) and that it would add corporate debt to its potential purchases.
Nothing startling there but more than expected.
But Draghi then said that the central bank is done–at least for a while. “From today’s perspective, we don’t anticipate it will be necessary to reduce rates further,” he said. The package “is an adequate reaction to a weakening of the growth and price-stability prospects,” Draghi added. “We think the measures we took today are adequate to address the change in economic conditions that occurred since our last monetary policy meeting.”
Which seems puzzling since he also noted that inflation is expected to remain negative (deflation in other words but without saying the “d word) in the coming months but will pick up later in 2016. (Inflation in February was a negative 0.2%.) The central bank lowered its inflation forecast for 2016 to 0.1% from the 1% forecast in December. Inflation will climb to 1.3% in 2017 and then 1.6% in 2018.
Last time I checked the math 1.6% is still less than the 2% target the bank has set as a goal for its program of asset purchases. And the bank is now projecting that inflation will remain below that target through 2018.
The European Central Bank also cut it forecast for economic growth in the EuroZone to 1.4% in 2016. That’s below the 1.7% growth in GDP the central bank forecast in December. The EuroZone economy will grow by 1.7% in 2017.
So let’s see–inflation lower than the target and economic growth tepid into 2017. Yep, I can see why the European Central Bank announced that it was done for a while.
On the news the euro climbed to $1.1207 against the dollar–after falling by as much as 1.6% earlier.
The most important take-away to me from today’s announcement and the market reaction is that traders and investors are becoming increasingly skeptical about the ability of central banks to stimulate higher growth and to generate higher inflation.
The bag of tricks announced today by the European Central Bank didn’t contain anything new and the same old, same old–even more of the same old, same old–doesn’t have the old magic that it once did.