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Nothing to See Here

August 2016 Market Update

We live in a strange economic world. We see headlines of new market highs, all while central banks around the world continue to use aggressive economic support policies normally reserved for times of crisis. Something doesn’t add up. The activity reminds me of that ominous feeling during an alien invasion movie when a convoy of military vehicles pass through a small town, but the officials insist, “everything is fine, there is nothing to see here.” If everything is truly fine with the economy, then what exactly have the troops been mobilized to fight?


A Twitter-Worthy Executive Summary

We believe current market valuations are being driven strongly by global central bank activity. We are concerned their efforts may backfire.


An Economic Dichotomy: All-Time Market Highs and Aggressive Global Central Bank Policy

The chart below, which I have used in past articles, demonstrates several different measures of market valuation. Historically, the worst that can be said about these valuations is that markets appear to still be slightly expensive, what optimists might call fairly valued, since most measures appear to be near their respective long-term averages.


Kelly, D. et. al. (June 30, 2016). Guide to the Markets. J.P.Morgan Asset Management. Data is as of 6/30/16.

 

The next chart demonstrates that the current economic expansion is the fourth longest in history and is approaching almost twice the length of the average expansion.

 


Kelly, D. et. al. (June 30, 2016). Guide to the Markets. J.P.Morgan Asset Management.

 

With all-time highs and one of the longest economic expansions in the last 100 years, it seems very strange that central bank policy remains in crisis mode, but that is exactly what we have seen on a global scale for over seven years.

Since the 2008 “Great Recession,” every major central bank around the world has engaged in various policies designed to support their local economy. At first, these policies consisted of the normal method of lowering interest rates to encourage borrowing, spending, and general economic activity, which then progressed to “Quantitative Easing” (QE) where central banks aggressively bought large quantities of government bonds to suppress borrowing costs. Who would have imagined that at all-time market highs (in the U.S.) and after a long expansion, we would have just witnessed the Bank of England cutting its interest rate to the lowest level in over 300 years? This cut also marked the 666th rate cut by a central bank since the collapse of Lehman Brothers in 2008.1

QE in Europe has been so aggressive that, “interest payments on savings accounts in the Eurozone are at the lowest levels since 2000, according to ECB data. In the early 1990s, it took nine years for a German saver to double his or her capital as interest income piled up, according to Hans Joachim Reinke, chief executive of Frankfurt-based Union Investment. Now, savers… would have to wait 500 years [emphasis added] for that to happen.”2  Rate suppression through bond buying remains so aggressive that the process is now being referred to as “negative interest rate policy” (NIRP) where some bond assets are actually guaranteed to lose money if held to maturity. NIRP has resulted in roughly 25% of the market of the approximate $43 trillion (with a capital T) debt market having negative yield. Again, that means 25% of all debt is GUARANTEED to lose money if held to full term. Obviously holding to maturity would not be a good long-term financial plan for these assets. However, as long as central banks continue to bid up the prices, the principal value of these assets could increase and yield fall even further negative.

 


Source: Kantchev, G., Whittall, C., and Inada, M. (August 8th, 2016). Are Negative Rates
Backfiring? Here’s Some Early Evidence.
The Wall Street Journal.

 

Looking at just government bonds, the primary targets of QE policies, we can see in the chart below that 36% of that market is producing a negative yield and a combined 74% are yielding less than 1%. These assets are normally relied upon by savers, investors, and pensions for their more secure investments. This historic quality may no longer be true in the future.

 


Kelly, D. et. al. (June 30, 2016). Guide to the Markets. J.P.Morgan Asset Management.

 

Policy makers believe that falling yields, on relatively safe assets like bonds, will force investors to venture further out of the risk spectrum in order to get the returns they need to hit their financial goals; which would in turn spur the economy and inflationary pressures. However, the greater necessary risk of higher yielding assets increases the uncertainty those growth goals can be obtained reasonably, and NIRP appears to be actually undermining global economic confidence, leading to an increased rate of savings.

Negative rates are primarily present in European Union countries as well as Japan, and the Wall Street Journal reports that respondents in those countries have stated that, “this odd policy of negative interest rates hasn’t motivated us to invest more. On the contrary, it’s a signal that the economic situation isn’t improving.”2 A growing chorus of, “economists and bankers contend that negative rates communicate fear over the growth outlook and the central bank’s ability to manage it.”2 Declining confidence in the world’s central banks is evident in the rising savings rates in many negative rate countries despite the lack of return. It would seem that return of capital has become more important than return on capital and investors are just increasing their savings rate to address the lack of return. The opposite of what central bankers wanted.

 


Source: Kantchev, G., Whittall, C., and Inada, M. (August 8th, 2016). Are Negative Rates
Backfiring? Here’s Some Early Evidence.
The Wall Street Journal.

 

The increased desire to save, and the emerging distrust of banks because of negative rates, has led to a run on private safe purchases in Japan. This kind of general public fear does not provide any type of confidence in the near-term economic outlook. Indeed this demonstrates that the public’s faith in, “the ability of policymakers to stimulate economic growth is dwindling rapidly, and both central banks and governments around the world are running out of options.”1

One central bank in particular, the Bank of Japan (BOJ), has already blown through the traditional methods currently being used by most other banks and has moved to even more experimental policies. In recent years the BOJ has moved its asset buying beyond just bonds and it is now buying the Japanese stock market through exchange traded funds (ETFs) that invest in a broad range of different Japanese companies. These efforts have resulted in the BOJ owning over 60% of the Japanese ETF market and that percentage is increasing further.

 


Source: Kitanaka, A., Nakamura, Y., and Hasegawa, T. (August 15, 2016). The Bank of Japan's Unstoppable Rise to Shareholder No. 1. Bloomberg Markets.

 

Like with bond buying, this massive and expensive effort appears to be backfiring.  The Japanese Nikkei 225 stock index dropped -18% over the last year (as of 8/15), despite the billions of dollars being invested by the BOJ. If the goal was to prop up market values, then this large loss would seem a massive indication of program failure. At the current buying pace, the BOJ is set to become the largest shareholder of almost a quarter of all Japanese public companies by the end of 2017.

 


Source: Kitanaka, A., Nakamura, Y., and Hasegawa, T. (August 15, 2016). The Bank of Japan's Unstoppable Rise to Shareholder No. 1. Bloomberg Markets.

 

Many politicians and market pundits represent the global economy as strong and deride any who would suggest otherwise. I would again point out that if the global economy is truly so “strong,” then why are such aggressive experimental policies being utilized across the globe? One of our greatest concerns about current markets is that a crisis of confidence may occur in regards to these programs. If that happens, the all-time high market valuations that have been supported by these programs become suspect. As has been the theme of these letters over the last year (you can see past issues here), we continue to believe caution is very warranted and are suspicious of officials telling us, “there is nothing to see here.” Perhaps that “nothing” is in reference to what an investor can safely earn in their bank savings accounts.

Ironic Uncertainty

A great deal of uncertainty remains in the present environment, ironically some of which is a direct result of those who aim to ease such concerns. For now, caution is still prudent as risks seem elevated. CWM PTS™ models continue to be invested very conservatively, as they have been all year, with no sign that positioning will change at any point in the near future. The CWM team will continue to be disciplined in our efforts to provide the best risk adjusted returns possible for clients; a goal we have achieved so far during this year’s bout of volatility.

Please pass this article on to any one you know who may be interested in or might benefit from the information. We are always looking for more great clients just like you and would welcome any opportunity to assist them.

If you have questions or comments about the above subjects or other investment topics, I would love to have a conversation with you! Feel free to email me at MorganA@CWMnw.com or if you are interested in more regular financial tidbits, follow me on Twitter.

Morgan Arford
Chief Investment Officer, Principal
MorganA@CWMnw.com

 

P.S. Remember, it is important to learn something new every day (and not take yourself too seriously).

 

References:


1) Martin, W. (August 8th, 2016). BARCLAYS: There is Nothing Left to Fight the Coming Economic Storm. Business Insider.
2) Kantchev, G., Whittall, C., and Inada, M. (August 8th, 2016). Are Negative Rates Backfiring? Here’s Some Early Evidence. The Wall Street Journal.
3) Kitanaka, A., Nakamura, Y., and Hasegawa, T. (August 14, 2016). The Bank of Japan's Unstoppable Rise to Shareholder No. 1. Bloomberg Markets.
4) Kelly, D. et. al. (June 30, 2016). Guide to the Markets. J.P.Morgan Asset Management.

This article has been prepared and distributed for informational purposes only and is not a solicitation or an offer to buy any security or investment or to participate in any trading strategy. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice as individual situations will vary. For specific advice about your situation, please consult with a financial professional. Past performance is no guarantee of future results.

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