Currency Wars – It's On!

Currency Wars – It's On!

2015-01-26 Currency WarLast Wednesday the European Central Bank (ECB) announced that it is launching its own quantitative easing program that was double what had been rumored, at an impressive €1.2 trillion. ECB Chairman Mario Draghi was able to pull off a program of this size by having some 80% of the bond-buying executed by national central banks. The agreement is that Germany will only buy German government bonds, France will only buy French bonds and so on. This was key to getting the program approved because if Spain or Italy goes off the rails, the German Bundesbank’s balance sheet won’t be immediately devastated. This is the main driver behind the rally in German bonds beyond the periphery bonds, which is also driving the rally in US bonds, as the markets can’t indefinitely maintain such a large spread between the only perceived risk-free rates left!

Despite all the rhetoric concerning how the economy is so very ship shape and all is going well on at least this side of the Atlantic, last year the best performing sectors were defensive ones: utilities and healthcare. This year with the crash in oil prices, the energy sector is forced to significantly delay capital expenditures and will by necessity put downward pressure on wages. Gasoline and diesel prices across the US have now fallen for a record 16 straight weeks. For the rest of the economy, the threat of global slowing and deflation may make many businesses hesitant to invest aggressively in expansions.

Central bankers across the globe have been on the frontlines of the newest form of international altercations, currency wars, which is driving yields into truly bizarre territory. Two weeks ago the Swiss National Bank removed the three-year currency cap on the franc and cut key rates having told the market just a month earlier that there were in fact no plans to remove the cap, sending markets into a veritable tizzy. India cut its key rate by 25 basis points and Bank of Korea lowered its outlook. Last week the Bank of Canada surprised everyone by lowering its main interest rate by a quarter percentage point for the first time since 2009. In Japan, Bank of Japan Governor Kuroda cut the nation’s core inflation forecast to 1% from 1.7%. Earlier last week the International Monetary Fund cut its forecast for inflation in advanced nations almost in half.   The result of these moves has left the Swiss 10-year yield in negative territory, the German 10-year at 0.52%, the French 10-year at 0.70% and the Japanese 10-year at 0.23% given that expected rates of inflation are all above these levels in their respective nations, 10-years in much of the develop world are now in negative real yield territory.   The currency war is on!

Those negative real yields reflect that most European countries are in or nearly in a recession. Italy for example is in a recession for the third time in six years, suffering from a 9% drop in output since 2008, and with unemployment increasing steadily from 7.8% in 2009 to 13.4% in November 2014. The ECB is expected to inject a massive monetary stimulus in an attempt to bolster the economies of these beleaguered nations, but the root of the problem isn’t monetary, thus the solution cannot solely be monetary. For example, in the January 10th edition of the Economist, Rwanda, which was in a bloody civil war just 20 years ago, is now cited to be a better place to do business than Italy! (Remember how we earlier mentioned that it is easier to start a business in Italy than in the U.S.?) No amount of monetary stimulus can fix those structural problems.

So we have defensive sectors outperforming and a material decline in trading volume, which tells you that investors are nervous.   Which brings us to the recent turn around in the yellow metal. Gold has traditionally had an inverse relationship with the dollar. For example, over the past four years the SPDR Gold Shares ETF (GLD) has had a -0.45 correlation with the Amex Dollar Index (DXY). From December 15th through yesterday, that correlation had completely reversed to be 0.75.   In 2015 so far, the correlation has been a mind-boggling 0.84! That’s a nearly perfect positive correlation. With central bankers around the world under pressure to manipulate their currency so as to inflate asset prices rather than having elected politicians deal with the very real structural problems, we believe it is no surprise to see gold once again showing strength. It has long been viewed as one of the only reliable stores of value and as long as the currency wars wage, will likely show continued strength, albeit with bumps along the way.

June Market & Economic Overview – A Tale of Central Banking

June Market & Economic Overview – A Tale of Central Banking

“The Future Ain’t What it Used to Be” Yogi Berra

Much of the recent economic data has been well below the hopes and expectations of governments and market pundits around the world. First quarter US GDP growth was revised down from +0.1% to an actual contraction of -2.9%, making the first quarter of 2014 the worst quarter since the first quarter of 2009, in the heart of the recession. The bulk of the revision came from weaker than expected personal consumption and a bigger than expected decline in exports. It is rare to see such a substantial decline without the economy being in a recession. That being said, most of the macro data for Q2 is looking like we’ll see a rebound with the economy gaining momentum rather than entering a recession, but we are paying close attention.

 

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European GDP growth was also decidedly lackluster, with Japan the only pleasant surprise, but its strong growth in Q1 is likely just pulled forward from Q2 when the nation’s VAT increased 60%, from 5% to 8%. When a tax increase like that is approaching, people tend to buy things in advance and stock up knowing that prices are going to increase in the near future, distorting quarterly purchasing data (which frankly irks your meticulous author who has an arguably unhealthy love for clean data). China’s growth in Q1 also fell below the government’s target and grew at the slowest rate since quarterly data was first made available starting in Q4 2010. Meanwhile geopolitical tensions continue to mount, putting the U.S. in the odd position of now potentially working with Iran in order to improve the situation in Iraq. The saying that politics can make for strange bedfellows comes to mind!

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In response to the continued economic weakness, the monetary policy positions of the four biggest central banks, the US Federal Reserve (Fed), The European Central Bank (ECB) the Bank of Japan (BoJ) and the People’s Bank of China (PBoC) remain quite easy (in monetary terms), with some even easing further in the belief that this will raise asset prices. This in turn is believed to be necessary to get the wheels of their respective economic engines moving faster. These regions represent about 60% of world GDP and 70% of the world’s equity capitalization, thus their actions have an ability to dominate the markets. The chart above shows just how dramatically interest rates have been suppressed. This suppression has generated all kinds of wonky market ramifications as reasonable yield becomes more and more of a mythical unicorn.

“Financial markets are euphoric, in the grip of an aggressive search for yield…and yet investment in the real economy remains weak while the macroeconomic and geopolitical outlook is still highly uncertain.” Claudio Borio, the head of the BIS’s monetary and economic department.

On June 5th, the ECB announced that it will cut its deposit rate to -0.1%, which means it now charges banks for holding excess cash, an ironic move given the concerns over the quality of European bank balance sheets. It’s a rather bi-polar relationship there with demands for the banks to clean up the quality of their loans on the one hand, and then penalizing them for not loaning out more on the other. Sounds like the makings of a central bank themed Lifetime channel movie! By Friday of that week yields on Italian and Spanish debt touched all-time lows. By the following Monday, Spain joined several other European countries, including Ireland, France and Germany, whose debt has lower yields than that of 10-year Treasuries. The markets appear to be following Salvador Dali’s advice, “What is important is to spread confusion, not eliminate it.” On that note, the riddle of this relentlessly rising market has left many bewildered, with trading volumes, or the lack thereof, attesting to the consternation. Volatility has also plummeted, thanks in no small part to central bankers around the world who are hell-bent on driving asset prices up while purely by coincidence, (without a trace of sarcasm from your author) making sovereign debt easier to bear. We aren’t the only ones to have noticed this and to be concerned.

“Volatility on the financial markets in the advanced economies has subsided to well below the historic norm, reaching levels that in the past sometimes preceded rapid changes in the orientation of investors.” – Ignazio Visco, Governor of the Bank of Italy The lack of volatility is “eerily reminiscent” of the run-up to the financial crisis in 2007-2008. – Charles Bean, Bank of England Deputy Governor

The S&P 500 has not dropped below its 200-day moving average since early November of 2012. It has continued to set a series of record peaks and has left volatility in the dust. The 10-Day A/D line (Advance/Decline Line) has been at extremely elevated levels (+2,500) since 5/30, excluding the first two trading days of June. As of June 30th, the S&P 500 has gone 409 days without going below its 200-day moving average. This has broken the previous record over the past 50 years of going 385 days without testing the 200 day-moving-average in 1995-1996.

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There isn’t much conviction around these highs, as the volume of trading has been quite low, illustrated in the chart at right. JP Morgan recently warned that its trading volume will likely be down by as much as 20% while Citigroup’s CFO announced that he expects Q2 trading revenue to fall by as much as 25% compared to last year. Recently the performance of the iShares US Broker-Dealer ETF (IAI) has diverged dramatically from the S&P’s upward march, illustrating this concern. Last quarter S&P 500 profits grew by all of 2% over a year ago, while stock prices continued to move up more aggresively, despite consensus estimates for an 8.5% increase in profits. The pattern of stock returns by size is also concerning. In general, stocks with higher market capitalization are performing far better than those with smaller capitalizations.

Year-to-Date Style Returns:  Morningstar indexes

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So profits aren’t great, which isn’t terribly surprising given the dismal GDP growth rate for Q1 and larger capitalized companies are outperforming smaller. If we look a little deeper into just who is doing the buying, we find an explanation for some of this. Turns out, that the usual buyers of stocks such as hedge funds, pension funds, mutual funds etc. have been in aggregate net sellers, the big buyers have been the companies themselves! Hold on a minute. Stock prices have been going up because companies are buying back their own stocks? S&P 500 companies bought back $160 billion of their own stocks in just the first quarter of 2014. Now there isn’t anything innately wrong with companies buying back their own stock and in fact we are often quite in favor of it, but there is a reason to be concerned when it appears that these buybacks are a significant driver of upward market momentum! We’ve seen a disturbing trend with these large companies issuing bonds in order to buyback their own stock, which we are sure has nothing to do with executive compensation packages tied to stock performance, (not even attempting to hide the snarky undertone here) such as with Monstanto, Apple, Cisco, and Fedex. As of February 26th 2014, companies had already raised at least $11 billion worth of debt in 2014 after having raised $19 billion in 2013 to help finance stock repurchases, according to the Financial Times.

Bottom Line: Stock price gains generated through repurchase programs funded by companies borrowing large amounts courtesy of central bank sponsored insanely low interest rates is something that ought to make everyone nervous. (Ok, so that was a mouthful, but it is an important point.)