James Bevan: Confident bulls and desperate measures
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ECB president Mario Draghi
With Passion Sunday at the weekend, it’s timely to note that we’ve had “seven fat years” since the bull market began on 9 March 2009. Over that period the S&P500 rose close to 200%. During this time, S&P500 forward revenues rose 3.2% per year on average whilst forward profit margins rose from 7.0% to 10.6% and forward operating earnings increased 12.4% per year on average. The index’s forward P/E rose from 10.2 to 16.3.
While we can remain in the bull camp for now, we recognize that the next seven years are likely to be leaner for investors than the past seven years.
Indeed, given the historically high levels of the profit margin and the valuation multiple, the most plausible dream scenario would be that stock prices rise at the same pace as earnings, which should increase at the same pace as revenues.
Realistically, given the prospect of non-cyclical stagnation with subdued inflation for the global economy, the historical trend of 7% for both may be too optimistic. The new trend may be more like 5%, with better returns coming from good stock-picking.
The bull run has been punctuated with a series of falls and rallies, and the S&P500 is up 10.6% for the period from 11 February to the close on Friday. The roots of the renewed confidence in markets can be traced to Euroland and the European Central Bank (ECB), China, the US and the Fed, commodities credit and technical factors.
Free toasters
With Euroland and the ECB, even if Mario Draghi’s powers are limited, last Thursday, the ECB announced six different measures (detailed in a press release) including an increase in the ECB’s QE from €60bn a month to €80bn starting in April. There was also the introduction of four targeted longer-term refinancing operations (TLTRO II) to run from June 2016 to March 2017.
With the QE, certain classes of non-bank corporate bonds were added to the ECB’s list of eligible securities. The specifics of this “corporate sector purchase programme” were detailed in another press release.
Under TLTRO II, banks can borrow for up to four years, as outlined in yet another press release. Initially banks will pay no interest, the new main benchmark rate. But if the commercial banks meet certain criteria, they will get a bonus of 0.40% annually on the value of the loan after two years, applied retroactively.
It’s as if your bank offered you a no-interest loan, plus a free toaster as a bonus. In addition, the interest rates on the main refinancing operations of the euro system and on the marginal lending facility were lowered to 0.00% and 0.25%, respectively.
Mr Draghi said that these latest efforts were aimed at further strengthening “the pass-through of the Eurosystem’s asset purchases to the financing conditions of the real economy”.
The concept of the ECB effectively paying banks to borrow from the ECB was introduced to eliminate the burden of negative interest rates on bank profits.
It came as a surprise, as the introduction of something similar to the Bank of Japan’s tiered system was more widely expected.
Mr Draghi said that the absence of such a system reflected not only the desire “not to signal that we can go as low as we want, but also the complexity of the [Eurozone’s banking] system.” As we know, negative interest rates were introduced on 5 June 2014, but failed to boost lending in Euroland with corporations having limited appetite to borrow.
On the currency front, the ECB did succeed in lowering the foreign exchange value of the euro after negative rates were first introduced but so far, the latest round of easing has actually boosted the euro.
Unfortunately, whatever relief may come for Euroland’s economy from the ECB’s latest desperate measures might be short-lived as the bank runs out of options, although Mr Draghi certainly hasn’t given up on trying to find ways to stretch the limits of monetary policy.
If not monetary policy, then what?
On the positive side, January’s industrial production numbers may be the first hint that the 20% decline in the euro since its 6 May, 2014 peak may be providing some stimulus to the Euro area. There were solid output gains (excluding construction) in Germany (+2.9%mom), Italy (+1.9%mom), and France (+1.3%mom).
Of course, the most immediate bullish impact of the ECB’s latest shock-and-awe extravaganza was a dramatic decline in the cost of insuring bank debt, which caused the EMU MSCI Financials stock price index to jump 5.6% on Friday.
That helped to boost the S&P500 Financials by 2.7% and the S&P500 Diversified Banks index by 2.8% last Friday. The plunge in all these financial indices earlier this year contributed to the panic attack that set the stage for the current relief rally.
The ECB’s latest moves were opposed by the Bundesbank. The ECB’s vice president Vítor Constâncio defended the latest actions in an opinion piece of 11 March posted on the bank’s website.
His main point was reminiscent of former Fed chairman Ben Bernanke’s reflection that the Fed did what it had to do during the latest financial crisis while fiscal policymakers in Congress failed to step up.
In this instance, Constâncio argued: “To normalise inflation in the euro area we urgently need higher growth that can reduce negative output and unemployment gaps, using all really available policies. If not monetary policy, then what?” He went on to say:
“The G20 has appealed for the use of other policies, notably fiscal and structural reforms… More generally, countries that could use fiscal space, won’t; and many that would use it, shouldn’t …Structural reforms are essential for long-term potential growth, but it is difficult to see how they could spur growth significantly in the next two years … And as regards their delivery by governments, we should recall the embarrassing results of the G20 plan agreed in Brisbane to generate an additional 2% in world growth via a long concrete list of reforms put forward by the IMF and the OECD … So if these other policies either can’t or won’t contribute to a significant degree, then not only is it wrong to start talking down monetary policy – it’s actually dangerous.”
Excess capacity
Turning to China, its government is also committed to doing whatever it takes to transform its economy from manufacturing-led to services-led growth.
The draft outline of the latest five-year plan was unveiled on 5 March and will be finalized on 16 March, when the national legislature’s annual session draws to a close.
It acknowledges that there is too much excess capacity in manufacturing, particularly among state-owned enterprises (SOEs).
There are reports that the government intends to reduce employment in the steel, cement, and mining industries by five to six million collectively. Funds will be allocated to cushion the hardship of the workers that are made redundant.
Meanwhile, industrial production rose 5.4%yoy during February – it’s slowest rate of growth since February 2009. The Producer Price Index was down 4.9% year-on-year during February and that’s the 48th consecutive monthly decline.
All this confirms that China’s economy is facing serious challenges, including avoiding massive debt defaults by the downsizing SOEs.
Investors were relieved last Thursday when it was announced that China is planning to convert some of the debts of the SOEs into equity.
The swaps would curb bad-loan levels just as they did during the country’s 1990s banking crisis, when about 30% of the nation’s 1.4tn yuan ($216bn) of soured credit was resolved through debt-to-equity swaps.
Under China’s current banking law, debt can be swapped for equity if shares were used as collateral for the loan, though banks in this situation must unload the equity within two years.
Banks seeking to swap debt for equity that was not used as collateral must obtain approval to do so from the State Council, which is the nation’s cabinet.
By the way, the huge $387bn jump in bank loans during January now seems to have been an aberration, as the pace slowed significantly back to a more “normal” $124bn last month.
Dissipated fears
Turning to the US and the Fed, there is big relief that widespread fears of a US recession have mostly dissipated as the Citigroup Economic Surprise Index rebounded from a recent low of -55.7 to -9.3 on Friday and last Thursday, it was announced that initial unemployment claims have fallen to 259,000 during the week of 5 March – the lowest since mid-October.
But with recent Fed briefings, virtually no one is expecting a rate hike at the 15/16 March meeting. The futures market currently suggests that two hikes are expected this year and we shouldn’t be surprised if, during her press conference on 16th March, Fed chairman Janet Yellen says that she is willing to postpone the next rate hike for a while because the 1.5mn jump in the pool of labour over the past three months through February shows that there is plenty of slack left in the jobs market.
That’s confirmed by the slow 2.2% move up in wages. She might even say that normalization of the labour market is more important than proceeding willy-nilly with monetary normalization meaning there could a delay of hikes until wages begin to rise rather than when inflation rises.
Also, with presidential election coming up, we might regard no, or, just one rate hike, as the most likely Fed policy scenarios.
As for commodities, investors are clearly relieved that prices seem to have bottomed with the CRB raw industrials spot price index well up from its 23 November 23 low, and the metals component bottomed on 13 January. The price of a barrel of Brent bottomed on 20th January at $27.88, and is up 45% since then.
With regard to credit, despite the bursting of the commodity super-cycle bubble, there hasn’t been a financial crisis. The yield spread between corporate junk bonds and US Treasuries did widen dramatically from the most recent low of 253bps on 23 June 2014 to the recent high of 844bps on 11 February.
However, it is back down to 640bps. Investors are therefore comforted that the fall in commodity prices has not triggered a financial calamity comparable to the crisis of 2008.
Finally, on the log of technical issues, there are chartists who warn that this is a “dead cat bounce” and a rally in a bear market.
They point out that the bull market is actually only six years and two months old since the record high was hit on 21 May, 2015, which was 204 trading days ago.
In other words, from their perspective, failing to take out that high soon in this relief rally could confirm that a bear market is underway. However, even the bears must concede that the breadth of the market is showing signs of improving.
Since 11 February, the S&P500 is up 10.6%, while the equal-weighted S&P500 is up 13.6%. For noting, while the former is up 198.9% during the seven-year bull market, the latter is up 280.9%. The NYSE volume advance/decline line is up 10.4% since the week ended 12th February – and the S&P500 Transportation index is up 14.7% since 25th January, back near its 200-day moving average.
James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla
*CCLA is a supporter of Room151
