After a high-yield scare and a hike in U.S. short-term interest rates ended 2015, markets swooned amid rhetoric of a global recession to start 2016. Yet the situation did not take long to improve, and the solid inflation and jobs data from the first quarter of 2016, along with continued central bank accommodation, offered further support. Here’s a look at how these and a few other notable economic developments are shaping our views looking into the second quarter of 2016.
If, after toasting New Year’s Eve, 2016, you had fallen asleep in your champagne glass and awakened in late March, you might be excused for looking around and concluding that no time had passed.
A panicked January saw investors selling off riskier assets, and by February 11, global equities had fallen more than 11% in the space of six weeks. U.S. high yield fell 6% in the same period. “Sell everything except high-quality bonds,” said the Royal Bank of Scotland (RBS).
RBS was not alone in its negative prognosis. The “Fed’s next move is toward Quantitative Easing (QE), not tightening,” Ray Dalio said. Cornerstone Macro predicted, “There’s only a 1% chance all the selling is over after a mere 11% drop in the S&P 500.”
But things turned around, and in another six weeks such doomsayer predictions turned out to be either flat-out wrong or in need of severe revision. The rebound after February 11 proved to be just as dramatic as the plunge leading up to it. By late March the U.S. market was back to flat for 2016, and most investors were likely admitting, along with the Macro Research Board, “the economic outlook is not as poor as investors feared just a month ago, particularly in the U.S.”
Such concentrated drama amounting to little difference no doubt holds many lessons for investors, not least the importance of separating short-term noise from the bigger picture. For in terms of larger directional moves, we find at the end of the quarter that despite a rocky ride down and a swift ride up, not much has changed.
So how should asset allocators respond to markets like those in January and early February? Readers of our Strategy Spotlight may recall our position in early January and our openness to tactically adjusting our strategy if we saw opportunities created by continued instances of elevated volatility. The selloff and rebound did give us a unique opportunity to scrutinize our process and to test our decision making and the long-term time horizon we have for most of our positions.
In short, we determined the selloff to be driven primarily by sentiment and we increased exposure to risk assets accordingly. We sketched out a plan with levels at which we might increase exposures to certain positions; we hit those levels, reviewed our thesis, and evaluated additional risks; then we responded by making adjustments when we found little to support such a dramatic decline. We increased equity and high-yield exposure (where risk budgets allowed) and then reduced both toward the end of the period. The result was the execution of a disciplined, consistent process.
Revisiting equity overweight
Any extended movement in the market should give investors reason to question their theses. Part of our process following the January selloff involved taking a step back in mid-February and revisiting our thesis for being overweight equity.
First, in absolute terms, while global equities are fully valued, they still offer attractive absolute and risk-adjusted returns. This is particularly true when comparing them to high-quality government bonds, and this divergence has widened in recent months. Second, we noted in last quarter’s outlook that the European Central Bank (ECB) and the Bank of Japan (BOJ) stood ready to extend or increase their easing measures if growth or inflation fell short of their objectives. This is still the case. Deflationary fears have been subsiding and inflation, while low, has been stable. Global economic growth has been expanding modestly, and liquidity remains abundant, with the U.S. in good shape and Europe modestly recovering. Lastly, we think the current Federal Reserve (Fed) rate hike forecast looks manageable: low and slow.
Coming into 2016, the main “bear” issues were well known. China’s growth had been slowing (and continues to slow), but we believe a hard landing remains unlikely. Oil prices had fallen, but low oil prices are not universally bad for global equities, and markets have largely been pricing them in. The marginal impact of central bank stimulus has been diminishing, but this too was not a new discovery.
Other key risks: worries that the Fed’s December rate hike was a mistake, and it will err by hiking further in 2016, and that valuations are too high. Perhaps more crucially, we’re monitoring the possibility that investors will lose faith and through a self-fulfilling prophecy create a recession. The efficacy of central bank policy in an environment of continued easing, and, relatedly, the potential impact of negative interest rates, also loom in discussions.
Our thoughts on these main risks are below.
U.S. consumer still signaling strength
A couple months of perspective shows the market’s behavior at the start of 2016 might have been a matter of focus. Given several economic leads to follow, among them fallen manufacturing data from December and continuing strong employment and solid inflation data, the market clearly chose to focus on the weak data and ignore the strong data.
Recall that in January, U.S. Institute for Supply Management (ISM) manufacturing data for December came in below expectations, as did the Caixin Manufacturing Purchasing Manager Index (PMI). At the same time, unemployment rates in the U.S., Japan, and Europe all continued to tick lower. The U.S. unemployment rate is now at 5%; Japan’s is near 3%; the eurozone’s sits at 10.3% — a full 1% below where it was a year ago. Additionally, Services PMI data have been fairly strong globally.
Our Strategy Spotlight in February cited several reasons we believe the U.S. consumer will continue to drive the U.S. forward and keep us out of a recession in the near future. We find these just as relevant looking into the second quarter: real personal income is rising; lower oil prices alone have never caused a recession in the U.S.; and no recession has ever started with today’s low unemployment rate.
On top of this, real consumption rose 3.1% in 2015, U.S. auto sales have climbed swiftly and steadily since 2011, and consumers are saving as well as spending. It is difficult to believe sentiment will have anything but a temporary effect on such strong fundamentals.
Dovish Fed downplaying rising inflation
In March the Fed maintained the federal funds rate at the 0.25%–0.50% range it set in December and released a dovish statement, lowering expectations for increases in 2016 (the Fed “dot plot” now predicts two hikes this year instead of four).
The Federal Open Market Committee’s March statement cited the effects of declines in energy prices in its expectations of low inflation in the near term, yet it is worth noting that inflation numbers for February released the same day were hardly depressing. While year-over-year headline inflation was down to 1.02% from January’s 1.37%, core inflation was up to 2.33%, an increase from January’s 2.21% and the highest core inflation has been since May 2012. At the end of May 2015, year-over-year core inflation was 1.7% — it has been slowly rising since.
Central banks and the new zero
The ECB and BOJ both cut rates in the first quarter and extended their accommodative stances. On January 29, the BOJ shocked many by bringing its policy rate into negative territory, at -0.10%. On March 10, Mario Draghi surprised many when he announced the ECB was cutting its deposit rate by 10 basis points to -0.40% and its policy rate to 0.00%, increasing the ECB’s bond purchases, and adding corporate bonds to the eligibility list.
Both moves received volatile market reactions (earlier in January, Haruhiko Kuroda, governor of the Bank of Japan, had denied even considering lowering interest rates), and both have met with criticism from the public — many take negative rates as a form of financial repression or a sign central banks are nearing the limits of their powers.
While we are concerned about their effectiveness in the medium term, we believe central banks have sufficient ammunition in the short term.
Concerns over the impacts of negative rates have yet to produce any real signs of turmoil. And judging from the reaction to both ECB and BOJ rate cuts, many are forgetting that the negative-rate experiment is well underway. A quarter of government bond markets are currently in negative rates; this amounts to $7 trillion of government bonds that yield below zero.
Negative rates, but no negative effect yet
The Bank for International Settlements’ (BIS) quarterly review published in March 2016 included a study of the experience of the four central banks in Europe (Denmark, Sweden, Switzerland and the ECB) with negative rates in effect for more than a year. The study concluded that in these negative-rate environments “problems with money market instruments designed with only positive interest rates in mind have so far not materialised.”
The BIS found that the effects of negative policy rates were softened somewhat by exemption thresholds (according to which deposits below the threshold did not trigger the negative rate) and that, as a result, “the average remuneration was not necessarily the lowest in the jurisdictions with the most negative policy rates.” In other words, the average rate was actually above the official policy rate.
The study also noted that retail bank customers have so far been shielded from negative rates, and that there is a “fundamental policy tension if the intention of negative policy rates is to transmit negative interest rates to the wider economy”:
If negative policy rates do not feed into lending rates for households and firms, they largely lose their rationale. On the other hand, if negative policy rates are transmitted to lending rates for firms and households, then there will be knock-on effects on bank profitability unless negative rates are also imposed on deposits, raising questions as to the stability of the retail deposit base. In either case, the viability of banks’ business model as financial intermediaries may be brought into question.
So there are several softening mechanisms preventing negative interest rates from having widespread effects. But even without these, it would be difficult to see the immediate impact of negative rates. The impact of negative rates on portfolio balances, as they push investors into riskier assets than they typically hold, is a difficult factor to measure, as it is difficult to say how much capital would have flowed into lower-risk assets in the absence of negative rates. And as the BIS points out, not all investors are feeling the effects of negative rates — yet.
There will always be times when investors are tempted to sell everything except high-quality bonds. At such times it is vital to revisit the thesis for each portfolio position and determine if anything has changed. In some cases, one will conclude that there was a violation of the thesis due to either an identified risk or an unforeseen one. In other cases (as in the experience earlier this year), one will conclude that nothing fundamental has changed and that the thesis is still intact. Such reviews are a key component of a disciplined and consistent investment process. As we expect elevated bouts of volatility to reappear in the short-to-medium term, we are prepared to again respond to investment opportunities created by this volatility.
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