Doubtless these pearls of wisdom will be playing on many minds this year as the continuing uncertainties surrounding the prospects for China’s slowing economy, the price of oil, rising interest rates, currency wars, Middle East conflict, US Elections and the UK’s referendum on Europe, to name but a few, play out.
Last Quarter Review
On the 16th December 2015, Fed Chair Janet Yellen finally ended exactly seven years of ZIRP when she announced at the press conference following the FOMC meeting that the US Federal Funds Rate was being increased by 0.25% to 0.50%. Market participants would have been most disappointed if she had not raised rates to officially announce US economic “lift-off”, after the Fed had been threatening to do so for almost two years.
Many market commentators however, remain unconvinced as to the strength or likely endurance of the economic data emanating from the world’s largest economy. With GDP growth barely able to exceed 2% per annum more than six years into the post Lehman recovery, the concern is that the next business cycle recession may be just around the corner, at a time when the central bank has barely begun reloading its interest rate weaponry to counter the next downturn.
Meanwhile the Euro zone economy continues to be fragile, as both annual GDP (1.6%) and inflation (0.2%) remain stubbornly low, but markets appeared decidedly unimpressed with European Central Bank (ECB) President Mario Draghi’s additional measures announced in early December to extend the duration of the current quantitative easing, when the expectation had been for an increase in monthly bond purchases. The ECB left its benchmark refinancing rate unchanged at a record low 0.05%, but lowered the deposit facility by 10 basis points to -0.3% and extended its €60bn asset purchase program until at least March 2017.
In the UK, GDP growth in the third quarter slowed to 2.1% per annum from 2.3% previously, but encouragingly the latest unemployment data reached a seven and half year low at just 5.2%, albeit this did little to help stoke inflation which remained at a stubbornly low 0.1% year on year to November. Other significant economic developments in the UK saw the trade gap widen to £4.14 billion in October, which (excluding oil and other volatile goods) was the highest since records began in 1998.
Concerns surrounding the world’s second biggest economy continued as Chinese GDP grew at an annual 6.9 percent in the third quarter of 2015, slightly down from 7.0 percent in the previous quarter and the weakest since first quarter of 2009. The mainland Chinese stock markets recovered strongly after their third quarter crash (which temporarily shook global markets in August) and ended the calendar year up almost 10%.
Meanwhile at the Bank of Japan (BOJ)’s December meeting, Governor Haruhiko Kuroda claimed that quantitative and qualitative monetary easing (QQE) has been exerting its intended effects, and that accordingly the Bank will continue the program with the aim of achieving the price stability target of 2 percent. QQE increases the monetary base at an annual pace of about 80 trillion yen, and the BOJ will now extend the average maturity of government bonds it purchases to between 7 and 12 years, while additionally increasing from April this year the buying of exchange traded funds (ETFs) to around 3.3 trillion yen per annum.
Globally, both markets and policymakers seem unsure as to whether the collapse in commodity prices last year is a blessing or a curse. Just before Christmas crude oil prices fell to an eleven-year low of less than $36 a barrel, and many commentators fear that with the glut of over supply and weak demand the bottom could be some way lower!
In what turned out to be a disappointing year for most investment asset classes, the exceptions were the dollar which rose 12% against a basket of currencies, while the German, Japanese and Chinese mainland stock markets (if you could handle the extreme volatility of the latter) rose more than 9%. Additionally the UK medium and smaller company sectors rose 8.36% (FTSE 250) and 6.16% (FTSE Small Cap).
|Key Economic & Market Data||3rd Quarter GDP||12 month GDP||Base Interest Rate at End Dec 2015||Equity Index Returns - Last Quarter||Equity Index Returns - Last 12 Months||Sovereign Bond Index Returns - Last 12 Months|
|NB. GDP Data shown is to the 30th September 2015; Interest Rate, Equity & Bond Index Data is to the 31st December 2015; Equity Indices used: US – S&P 500, UK – FTSE 100, Eurozone – Euro Stoxx 50, China – Shanghai Shenzen CSI 300, Japan – Nikkei 225, Germany – Xetra Dax; Sovereign Bond Indices courtesy of Bloomberg|
The consequences of two significant developments during December potentially hold the key to the fate of global markets in 2016. The first which was given global media coverage was the decision of the Fed to increase interest rates for the first time in seven years on the 16th December, while the second (occurring on the 10th December) which had slipped under the radar of many investors, was the decision of a US mutual fund specialising in high yield bonds to suspend redemptions after assets had shrunk during the course of the year from $3 billion to $790 million on the back of the collapse in the oil price sector.
Looking firstly at the Fed’s decision to end ZIRP, many investors will be asking whether the seven year long equity bull market can continue against the headwind of rising interest rates, always assuming the central bank succeeds in raising rates further against the backdrop of continuing questionable economic data. The evidence from previous tightening phases since 1955, is most encouraging, as on all but one of the twelve occasions when the Fed began its cycle, the following three months resulted in the US equity market rising, with an average gain of 10.9% on the S&P 500 index!
The only exception during the past sixty years occurred in 1984 when three months after the Fed first increased on July 24th, the benchmark index was down 1.7%. When additionally you factor in that many commentators are convinced it will be “one and done” from the Fed due to a combination of poor economic data and strong headwinds, the prospects for US equities at least in the early part of 2016 look relatively reassuring.
Both the poor economic data in the US and other developed markets, as well as increasing headwinds, can largely be attributed to unprecedented debt levels (which in developed markets had grown from $142 trillion prior to the collapse of Lehman Brothers in 2008, to $199 trillion at beginning of 2015) and the failure of central banks to achieve their inflation targets despite the unprecedented amounts of money created through various quantitative easing programs and extraordinarily low levels of interest on borrowed money. If it turns out that the Fed was right to raise rates because the American economy proves to be stronger than sceptics believe, that should also prove positive for equities, while being negative for government debt and corporate bonds.
Many commentators believe however that the US will experience the same liquidity trap that ensnared America during the depressed thirties, and Japan during its deflationary nineties. The problem occurs when too many individuals and companies prefer to pay down debt, as opposed to borrowing to spend or invest, resulting in no amount of monetary stimulation such as QE being able to alleviate the deflationary trend.
Some economists such as Richard Koo at Nomura Research have termed this the “balance sheet recession” conundrum, and suggest the only way out of it is for extraordinary fiscal policies, when monetary policies such as QE and ZIRP have been exhausted. Former US Treasury Secretary Larry Summers appears to suggest a similar strategy, whereby essentially the governments of the developed markets take up the necessary excess consumption slack that the corporate and individual is refusing, through massive borrowing programs for infrastructure spending, etc. (regardless of whether it is actually required or not!) in order to keep economic growth positive.
With it being presidential election year in the US, it will be interesting to see whether this fiscal stimulation idea gains traction, as well as how much of an influence political change has on markets. Brian Belski, chief investment strategist at BMO Capital Markets, explains in his 2016 outlook, that presidential election years have produced an average S&P 500 annual gain of 7% versus 7.5% for all years, but in an interesting wrinkle that he finds quite relevant, election years in which a new president must be elected (as must happen this time) have seen the S&P lose 4% on average.
Secondly, markets will be nervously watching developments in the US high yield bond sector following some eerie similarities to 2007 and the prelude to the credit crunch. Back in 2007, the suspension of redemptions from a small number of investment funds run by French bank BNP turned out to be the warning catalyst for the unprecedented financial earthquake that subsequently hit markets.
The potential financial disaster this time rests in the oil and energy high yield bond sector, which has been devastated by an oil price collapse during the past eighteen months from more than $100 a barrel to less than $40, potentially giving rise to further restrictions placed on redemptions within credit markets and which some commentators are suggesting, resonate with the collapse of Bear Stearns immediately prior to the 2007 Great Financial Crisis.
Whilst we would agree there is danger of a lack of liquidity in some sectors of the Bond market, we would also agree with the views expressed in a recent article appearing in the “The Economist” entitled “Canary or canard” suggesting that, whilst it has to make sense for investors to keep a watchful eye on developments, there is no justification in making dramatic analogies with the 2008 sub-prime mortgage debacle. Instead data provided by Wells Fargo, the American bank, suggests the oil and energy sector which accounts for just $225 billion of the total junk bond market of around $1 trillion is much too narrowly based to cause contagion in the wider bond market, and it is also reassuring to know that unlike in 2007, none of the firms that are now in difficulty are systemically important!
The largest market and economy in the world will be distracted with its presidential election, and the distinct possibility that a political wild card like Donald Trump may not only win the Republican nomination but the race for the White House as well, while even more acceptable mainstream Republican candidates such as Ted Cruz advocate policies that could unsettle markets were they to be enacted, such as a flat income tax and the reintroduction of a form of the gold standard. Additionally, the S&P 500, which is already very expensive by historic standards, would have been sold down significantly in 2015, were it not for twenty or so popular super stocks such as Google, Facebook, Amazon, Apple and Netflix whose valuations continued to soar. Were investors to abandon these, 2016 could prove very challenging for the Wall Street benchmark.
Meanwhile, in the UK, the possibility of a Brexit will increasingly worry investors. Indications are that the referendum will be conducted sooner, rather than later, in anticipation of a successful outcome to the current UK/EU negotiations. Opinion polls however, point to a close run campaign with the ongoing uncertainty serving to make UK markets, and especially the pound, less attractive to foreign investors.
There can be little doubt that the year ahead presents investors with their toughest challenges since the current equity bull market (the third longest in Wall Street history) began in 2009.
Nevertheless, whilst we will inevitably witness a marked increase in volatility during 2016, and expect overall returns for the calendar year to be low in consideration of the risk premium involved, there remain relatively attractive areas of unrealised value across many sectors including; Continental Europe and UK small and mid-cap which tend to be less commodity and energy focused than the FTSE 100 Index and where businesses may indeed benefit from low energy prices and extended low rates of borrowing. We also anticipate the current environment will continue to be supportive of direct property funds, providing useful alternative investment diversification at this time.
From all of us at Ash-Ridge Asset Management, we would like to wish you a healthy, happy, and prosperous 2016!