The Oxford English Dictionary defines confusion as “the state of being bewildered or unclear in one’s mind about something.” Investors seem to be in a state of confusion about how to invest in this slow growth, increasingly monetarist global environment. There is simply no unifying theme giving investors a guiding light. There are, instead, many diffuse themes that investors need to decipher. These include, but are not limited to, the slowdown in China and its impact on emerging markets, Europe’s persistent need for stimulus despite negative interest rates, Japan’s massive quantitative easing (“QE”) and listless consumers, Britain possibly leaving the Eurozone (“Brexit”), and lastly, slow (but steady) U.S. economic growth. Each on its own is not hard to understand, but taken together they seem to paint a confusing picture.
Since we have written quite a bit about China in past letters, we won’t dwell on it too much here. China has long been a major driver of emerging market growth in South America, Africa, Australia and parts of Asia. This is principally due to its once insatiable demand for commodities driven by its investment-based boom over the past 25 years. Suppliers behaved as if demand would continue unabated and borrowed heavily to increase capacity. The 2008 financial correction slowed even the dubious official Chinese Gross Domestic Product (GDP) growth rate, from a peak of 13.9% in 2007 to a more tepid 6.8% in 2015. Chinese exports have also followed a similar path. Chinese officials have long known that a transition to a consumer-led versus an investment-led economy would be needed at some point. The latest slowdown has made the transitioning a bit more precarious for policy makers there, given the amount of debt they have added to their books, both to fuel growth and recently to stimulate their economy. The risk of a meaningful amount of this debt going bad is real, given the slowdown in their economy. They must now decide how to keep banks and other financial institutions healthy, while dealing with this potentially bad debt. Fortunately China has massive trade reserves that can be used to offset some of this, but time is not their friend.
Unfortunately caught in the backdraft of the Chinese slowdown are its commodity suppliers. These countries will continue to face headwinds as both prices and demand growth are expected to remain low for some time. We have seen well publicized collapses in the economies and currencies of countries in South America, accompanied by runaway inflation and a shortage of basic consumer goods there. This is now a major political headache for the current governments as the debt used to finance export growth has become a crushing burden crowding out much-needed investments in infrastructure and basic services. Despite a recent rally in both the currencies and equity markets of many emerging markets, we still see much volatility and uncertainty ahead.
Japan is dealing with its own self-inflicted problems. Over the last several decades, demographic changes (especially the graying of their population) and a slew of tax and fiscal policies that coddled corporate interests at the expense of citizens and consumers have caused a withering of growth from both constituencies. Several decades of QE have done nothing to push their economy into higher gear. Instead of accepting that QE has its limits, the Bank of Japan (BOJ) decided to push further in its attempts at stimulating Japan’s moribund economy. On January 29, 2016, the BOJ cut the interest rate it pays on excess commercial bank deposits to a negative 0.1%, joining Europe as the newest member of the negative interest rate club (we’ll get to that in a moment). The theory behind negative rates is that if you make it painful enough to hold cash by charging savers to hold cash or to pay borrowers (we know, it sounds crazy), then they should increase spending and thus cause growth. Sometimes theory sounds plausible, but in reality the opposite can happen, as it has here. Not surprisingly, the more you directly or indirectly tax savers, the more they will look at their future and realize they actually need to save even more to fund expenses into old age. Whether they do so under a mattress, in a coffee can buried in the backyard or in accounts outside of Japan offering higher yields, consumers will hold more cash, not spend it. Another miscalculation of Japan’s policy makers is the consumption, or sales tax. The tax rate is being raised in steps from 5% to 10%. In April 2014, the tax rate was raised from 5% to 8% and the top rate of 10% is planned for 2017. You could be forgiven for thinking that the slowdown in the economy following the last increase might cause Japan’s leaders to forgo any further increases, but sadly you would be wrong. Prime Minister Abe recently said that the rise from 8% to 10% will still go ahead as planned in 2017. With nonsensical actions like negative interest rates and sales tax increases causing even more sluggishness in Japan, it’s no wonder investors are wondering if monetary limits have been reached.
The real effects of these policies can be observed in the markets. We have seen demand for inflation-linked debt in Japan grind to a halt, and life insurance companies have decided to stop selling policies, as it is uneconomical to do so with negative interest rates. Additionally, money market funds are closing. Japan has basically tried everything short of dropping bags of Yen from helicopters, but so far their efforts have been relatively fruitless. Perhaps bold new thinking is needed, rather than continuing to pile on debt, to tax savers and spenders alike and hope that everything will turn out okay. It’s a pretty sad commentary on the state of the economy and life in Japan when the elderly are committing petty crimes in order to get arrested just to be provided the basic necessities that they can no longer afford. In fact, about 35% of shoplifting offenders are over 60 years old. If that’s not a sign that something needs to change, then what is? Stay tuned.
Given what’s happened in Japan, you’d think that the European Central Bank (ECB) would perhaps use a different playbook, but they have not. The ECB began implementing QE after the financial crisis and started its own negative rate policies in 2014. Since the implementation, Euro-area inflation has declined, even turning mildly negative in late 2014 and early 2015. In addition, consumer confidence has been getting decidedly worse over the last 12 months and the European Commission Economic Sentiment Index is at the lowest point in 13 months. While there have been a few positive developments, like a decline in unemployment, these have not offset the negatives of sluggish spending and investment and are not stoking any inflation.
Perhaps feeling they had not gone far enough; the ECB also recently increased its asset purchase program to include corporate debt. This could have the unintended consequence of possibly crowding out other investors. As we saw in the U.S. after the financial crisis, asset purchases don’t appear to stimulate long-term inflation. They may increase the wealth effect of investors, but this is viewed as temporary and is thus not spent. How radical is the ECB? Barclays Bank estimates that the ECB will be purchasing about a third of all newly issued corporate debt or about 10 billion Euros a month (120 billion Euros a year). Unless there is a major increase of new issues brought to market, the ECB will likely crowd out other buyers of debt. Also, is this what we really want: a further increase in debt when the economy is still mired in near deflation? We think not. We do not believe that the impact of these purchases will differ from the experience in Japan. Keep in mind that the Europeans still haven’t recapitalized their banks since the 2008 financial crisis and haven’t yet successfully reflated them out of trouble. While we admit that it is preferable for this surfeit of debt to be housed on central banks’ balance sheets, the result is still the same: an impediment to growth.
A weak Chinese economy, emerging market turmoil, continued Japanese economic malaise and a strained and struggling Euro-zone make for an interesting backdrop against which to examine the U.S. economy. The “risk off” selling that began in Q4 2015 paused briefly when the Federal Reserve (the “Fed”) began interest rate normalization in December and continued going into early 2016. Concern that slowdowns in emerging markets and China would stunt U.S. growth seemed to rule the day. Commodity prices hit multi-year lows. The S&P 500 fell over 10.5% while longer U.S. Treasury yields declined as investors around the world sought the safety of the U.S. government. Sentiment seemed to turn on February 11th when Saudi Arabia and the Organization of the Petroleum Exporting Countries (OPEC) reported that they would consider a freeze on increasing production of oil. Iron ore and other commodities also bounced as China said it was increasing steel production. Markets took these little grains of positive news and shrugged off other concerns and the markets rallied through quarter end. Gold, which many believe to be a “safe haven,” rallied hard early in the year as investors shed equities. What is surprising is that even after equities turned around in February, gold did not sell off. The precious metal seems to be acting as both a hedge against deflation during periods of market weakness and as a hedge against inflation during periods of market strength. Confusing indeed!
The Fed also seems to be conflicted. On March 16th, the Federal Reserve Open Market Committee (FOMC) held the Federal Funds rate steady. While the deliberate pace of normalization is no surprise, the Fed commentary was. Similar to the curveball the FOMC threw the market in September when they highlighted global economic and financial developments as rationale for not raising rates when economic statistics warranted that they do so, they repeated that refrain. Instead of focusing on the positive fact the U.S. is continuing its slow but steady growth, the committee decided to focus on global economic and financial developments. The Fed seemed to be genuinely worried about the impact of U.S. monetary policy globally rather than staying ahead of the curve on inflation here at home; hence we jokingly refer to their third mandate as world peace. Maybe it wasn’t a joke. The unemployment rate has continued to decline close to their 4.8% median forecast (consistent with a 2% inflation target) and their fluid target of full employment. Pretty soon the unemployment rate could be below their current target (read: good news). This would imply a rate rise is necessary as inflation is brewing and upward wage pressure could add fuel to the fire. The Core Consumer Price Index (which excludes food and energy) has been rising, and it is now above the Fed’s inflation target. Inflation may indeed be percolating higher; time will tell if this is transitory or not.
As we have mentioned, all of these big QE programs and negative rate policies have been funded by increasing national debt loads and printed money. This has ballooned central banks’ assets from about $2.1 trillion in 1995 to around $21 trillion in 2015. Let that sink in for a moment: a 10-fold increase. That’s a lot of assets bought by central banks over that period. Despite this, many regions (e.g., Japan and Europe) are still teetering on the precipice of deflation; obviously the prescription has not cured this bad case of “slow growth-itis.” The good news here is that there is interest income being generated by these assets and central banks don’t need to sell or mark to market. At least if you are going to add leverage, have it held by the strongest hands. This does raise the question of what may happen if a large central bank decides to sell from their hoard of Treasuries. China, which is America’s largest creditor, has recently been selling some of its holdings and so far the market has easily absorbed the supply. Primary dealers increased their holdings of Treasuries by over 100% from about $50 billion in December 2015 to around $110 billion in March 2016. Also, the Fed reported that households (read: hedge funds) and nonprofit organizations increased their holdings of Treasuries in 2015 by over 45% or $398 billion. So far, it appears that there is enough liquidity to absorb the selling of Treasuries by central banks.
While the markets took the dovish action by the Fed as an invitation to add risk, they ignored the elephant in the room that Yellen mentioned in her speech at the Economic Club of New York. She indicated that the Fed still has room in its balance sheet to do QE if markets warrant it. Considering the sovereign debt bubble is already quite inflated, it’s a little surprising the Fed would be willing revert back to a policy of questionable success. What’s even more shocking is that former Fed Chair Ben Bernanke has been advocating negative rates in his most recent blog posting for the Brookings Institution. It seems that Fed officials, both current and former, are equally nonplussed.
We admit that getting one’s bearings in these choppy seas is difficult, but we believe eventually these storms will calm down and we will have a clearer outlook on the future. Sometimes it is helpful to look at the world through a non-economist’s eyes. What we see is people going about their lives, unconstrained by the vagaries and daily gyrations of the markets. They buy products that they need or want, and companies provide those, hopefully at a profit to their shareholders. If the economy slows a bit, the remaining economic activity doesn’t disappear. People do not revert to living in caves and foraging for food. At the margin, profitability may be a bit constrained, but capable stewards of well-run companies can manage through this. Investors may be unsettled, but with confusion comes opportunity. It is our goal to find those well-managed companies that should ultimately succeed (and pay off their debts) at values the market is overly discounting today; these investments may include convertible bonds, high yield paper, preferred stocks or other types of bonds that we hope will be profitable in the long run.
Patience is often in short supply among investors. Last year we compared George Seurat’s pointillism to the Fed’s dot charts, where the closer you got, the less clear the picture. Today’s investment outlook reminds us more of a Jackson Pollock drip painting where the average person struggles to appreciate the uniqueness and the value in the seeming randomness of the art. Here’s to a cleaner canvas!
As always, we thank you for your continued trust in us and welcome any questions and comments.
Past performance is no guarantee of future results. This commentary contains the current opinions of the authors as of the date above which are subject to change at any time. This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
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Yield is the income return on an investment.
Quantitative Easing (QE) is an unconventional monetary policy in which a central bank purchases government securities or other securities from the market in order to lower interest rates and increase the money supply.
Gross Domestic Product (GDP) is the monetary value of all the finished goods and services produced within a country's borders in a specific time period.
The S&P 500 Index is an unmanaged index that is widely regarded as the standard for measuring large-cap U.S. stock market performance
Core Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services excluding food and energy.
One cannot invest directly in an index. 
© Osterweis Capital Management
© Osterweis Capital Management