We have never before lived through such an elongated period of zero interest rates. Now with negative interest rates in Europe and Japan we are once again in uncharted waters.
Even Warren Buffet admitted on CNBC, he can't answer the question, “What happens after negative rates?”
In Europe, and more recently in Japan we have negative interest rates on government debt out to ten years. Japanese ten year bonds yield -0.07 %, Swiss ten year bonds -0.48%. Germany offers + 0.11% with the Netherlands at +0.25% and France at + 0.47% for their 10 year maturities.
About 25% of the developed world's government bonds offer negative interest to debt holders. Who buys them?
Foreign central bankers apparently feel that a shock to the system after a long period of slow growth, low rates and low inflation would bolster their sluggish economies.
The expected effects of this policy were a weaker domestic currency versus the dollar, higher stock markets, greater economic activity and higher inflation.
While the jury is still out we witnessed the soar of the Yen and Japanese stocks down 10% right after Japan implemented negative rates.
Both Europe and Japan are hoping to avoid deflation and recession but both appear to be losing the battle. Equity valuations in both zones appear cheap but there is little confidence in European banks, Japanese economic reforms and a QE policy that seems to have gone about as far as it can go.
In the U.S. our Federal Open Market Committee moved in December, for the first time in 10 years, to raise short term rates. Markets have reacted with lower stock prices and lower long term interest rates on government debt. Our domestic 10 year bond yields 1.74% versus 2.17% at year end. This rate is still generous for a developed country and the world’s largest economy. Amazingly the U.S. yield is higher than the countries mentioned above, plus Italy, Spain and the U.K.
Not surprisingly over the past year world trade has contracted considerably along with energy prices. Consumers have yet to get the memo that they have more money to spend.
China appears to be an economic wild card as few believe official growth rates. Their domestic stock markets have dropped about 50% from the peak. Will they react with more stimulus?
The economy in the U.S. chugged along at 1% growth rate in the fourth quarter of 2015 with 1.3% inflation in a year over year basis.
China is growing perhaps 4-6 % with Europe at 1% and Japan back in negative territory. Brazil and Russia are in recession.
Interest rate spreads have widened materially versus government guaranteed debt and stocks have declined globally with the U.S. now catching up to foreign markets.
Confidence is dropping while investor sentiment shows Bears exceeding Bulls by 1% in the most recent Investors Intelligence survey.
Investors are rightly frustrated that positive returns have been concentrated in a few growth areas leaving the average holder of shares over the past year and one half with losses.
Experts have suggested avoiding long dated bond maturities for years, yet long dated Treasuries along with similar foreign government bonds and municipals have performed very well.
Riskier credits which central bankers encouraged with low rate policies have performed poorly by comparison.
In sum, markets lacks confidence, central bankers have run out of ammunition and political leaders in the U.S. and Europe have few answers to spur growth. The SPX is down 5.5% YTD with the NASDAQ down 9%. Both indices have dropped from last year’s peak levels by 9.5% and 12.9% respectively.
According to Factset at 1932.23 the SPX sells at 15.6x forward earnings of $124.2 still above 5 and 10 year average multiples. Analysts expect no pickup in SPX earnings until Q3 of 2016. Few economists expect an imminent recession with Wells Fargo recently putting the probability for a 2016 recession at 26%.
The FOMC is likely to stay pat in March with a 32% chance of another ¼ point raise in June and a 54% chance by December.
Uncertainty over the future leads to lower P/E multiples and we surely live in uncertain times.
Earnings will likely dictate the future market direction for stocks. Markets will fall and rise depending on the rate of global economic activity. Central bankers have done nearly all they can to help growth and employment, now we require genuine long term solutions.
Doug Coppola
John Coppola
March 1, 2016
