Sell in May? The Yen Carry Trade Sends a Warning

After having one of the worst starts in market history, equities bounced back in a big way, posting positive returns and overcoming a dreaded 10% correction. However, since the remarkable return, equities have run in to the proverbial wall as the calendar turned the page on April and set its sights on May and beyond, a period that is notorious for producing lower equity returns. But will "Sell in May and Go Away (to the Hamptons)" hold true to form in 2016 or are fears of a market slow down or worse warranted?

The Warning Signs

During bullish periods, traders often times will employ a trading technique called the "carry trade" where a trader sells one security with low yields and uses the proceeds to purchase higher yielding securities. Oftentimes the securities used are the Japanese Yen and the U.S. dollar. When the technique is being widely employed the Yen usually weakens, which is one desired outcome of the trade. The trade is completed when the Yen is repurchased with the sale of the higher yielding (hopefully) securities. The difference is the trader's profit. Therefore, a weak Yen is often viewed as confirmation of a bullish market trend. However, what happens when the reverse is true? Since the beginning of the year, the Yen has strengthened 12% against the U.S. dollar, initially confirming early weakness in equities. However, when equity markets rallied, the Yen did not confirm the bullishness and continued to climb. Was the Yen sending a signal about the strength and durability of the equity rally? It may or may not be, but recent equity weakness in the face of the seasonally weak period does not typically bode well for equity performance this summer.

It's About Earnings (and Fundamentals)

Seasonality and momentum can carry markets only so far, at some point earnings have to matter. Even though it's no secret that the Fed's hand has guided markets for years now, historically, equity performance has a high correlation with earnings performance. However, earnings have declined four quarters in a row, the first time since 2008, and equities have maintained lofty levels. At some point, something has to give. If there was a year, and season, to be cautious, it could be 2016. It's not just earnings that are acting as headwinds, falling economic indicators are painting a challenging canvas for equities to do well from current levels. Durable goods continue to underwhelm, as do consumer confidence and GDP. Although labor markets have shown resilience, wage growth continues to stagnate and payrolls actually might be about to rollover.

It's Still About the Fed...For Now

Despite the headwinds to higher equity returns, the game is still about the Fed and what it telegraphs going forward. This may not last much longer, however. Investors have been counting on weak data to suppress the Fed and its actions. Now that the market is not pricing in a June rate hike (only a 13% probability per the CME Group), weak data may start to be viewed as bad for markets, whereas, strong data may start to look like, well, strong data, and the market could interpret this as more Fed action. It's a game investors are playing but the end may be nigh as Fed options become exhausted.

Understanding Negative Interest Rates

The latest Central Bank tool used to combat slow economic growth are negative interest rates (NIRP). But what are negative interest rates and how does it work? For now, it's a policy being used outside of the US, in places like the Euro Zone and Japan. The Euro Zone recently went more negative while Japan went negative for the first time in its history. If the US Central Bank elects to use this policy what will it look like and how will it affect mortgage rates?

Who Uses NIRP?

The ECB, Denmark, Sweden, Switzerland and Japan are employing NIRP. The Euro Zone started using NIRP before deciding to use Quantitive Easing or asset purchases back in June 2014. Employing NIRP is a sign of economic desperation to combat deflation and slowing or falling growth. The ECB was the largest central bank to use NIRP. In January of 2016 Japan started using NIRP for the first time in its history.

Why Use NIRP?

When conventional measures to stimulate growth are not effective central banks turn to less conventional means to promote economic growth. Other non-conventional measures include asset purchases and zero-interest rate policies (ZIRP). In theory these programs are meant to stimulate borrowing and promote spending by businesses and households.

Why They Might Not be Effective

Lowering interest rates was meant to stimulate borrowing and encourage consumption by businesses and consumers. Unfortunately, businesses have not borrowed to the extent that central banks had hoped and capex has flatlined or fallen as businesses have not found the demand needed to justify investment. In regards to consumers, lower rates meant to encourage refinancing by homeowners was stifled by a lack of equity allowing for bank lending. Once homeowners successfully refinanced their homes, the savings were either put in the bank or went to pay down other debt items therefore failing to invigorate the moribund economy.

Are They Coming to the US?

NIRP is an option for the US but as of now Central Bank president Janet Yellen has not elected to employ them. If the US can hit its inflation target of 2% the Central Bank will likely not use NIRP, however, if the economy stalls and deflation becomes a threat, Janet Yellen may be forced to use NIRP. It would mean lower borrowing costs for businesses and households. Consumers will have another chance to refinance their mortgages to an even lower payment. 1% on the long bond will become a reality and mortgage rates could hit 2% on the 30-year mortgage.

Are Banks Going to Charge Consumers to Save?

As of now, this is not how NIRP is being employed. Central Banks are charging large financial institutions to park funds with them. The Euro Zone recently moved the rate it charges institutions to park money with them to -0.30%. This is meant to dissuade lenders from parking money at the Bank and to encourage them to lend it out to borrowers. Consumers are not being charged to keep money in a savings account nor are they being paid to borrow.

The Danger of Market Distortions

Analysts are critical that NIRP and other non-conventional monetary policies may have adverse effects on financial markets and may lead to further difficulties than those they are meant to solve. Obvious casualties of NIRP are lending institutions and financial institutions that rely on spreads between interest rates to make profits. Banks borrow at low rates and lend at higher rates to make profit. As interest rates come down those spreads get squished and profits fall. When rates go negative these institutions incur costs that may pass on to consumers to maintain profit margins. If not, they become less profitable. Part of a healthy economy is a healthy financial system made up of healthy banks. If they become compromised and find less incentive to lend, credit markets could suffer and markets could be facing another 2008 style calamity. This is the danger of market distortions.

2015 Market Results/2016 Outlook

Happy New Year! As we welcome the arrival of a new year it is important to look back on where we have come from. How did major markets perform in 2015? What can and should we expect in 2016?

2015 Results

Equity Indices
Dow Jones Industrials: Down 398 or 2.3%
S&P 500: Down 14.96 or 0.70%
Nasdaq: Up 271.36 or 5.6%
Russell 2000: Down 68.81 or 5.9%

Commodities
Oil: Down 16.40 or 36.6%
Gold: Down 125.90 or 11.2%
Copper: Down 0.69 or 28.1%

10-Year US Treasury
2.2694% yield up 0.10% or 4.5%

Currencies
Euro/US Dollar: Down 0.09 or 8.3%
USD Index (DXY): Up 8.32 or 808%

Summary
2015 proved to be a challenging one for money managers and all investors. Between a strong US dollar and the weakening commodities complex, returns were hard to come by as companies struggled to post positive earnings. Most asset classes were down. It paid to be diversified in overseas markets as Europe, Russia and Asia outperformed. Investors spent the entirety of 2015 fretting over the timing of the Fed's first rate hike in 8 years. The Fed's first rate hike finally came at the December meeting.

2016 Outlook

If the first trading days of 2016 are any indication, it could be another rough year for investors. Many pundits are "spinning" a bullish story based on historical performance following flat years. Last year the "story" was bullish based on the 3rd year in the presidential cycle AND positive returns during years that end in 5, like 2005 or 2015. Bulls always need a "story" or a yarn to spin and they keep churning them out. Maybe they should just stick to fundamentals, the markets do. Earnings performance are still the most reliable metric for market performance even if the market may stray away briefly.
So, what can markets look forward to in the new year?

The Fed: the market will watch the Fed closely for any indications on future rate hikes.
China: the world's second largest economy influences many economies, particularly emerging markets. The US fears further currency devaluation and its effects.
Commodities: how low can oil go? The big danger is the collapse of an entire network of derivatives connected to the commodity.
Corporate Earnings: earnings growth has slowed as well as top line revenue growth. Can stocks go up in the face of declining earnings growth?
Geopolitical Concerns: Saudi Arabia v Iran row, N. Korea testing an H-Bomb. Is North Korea a black swan?

Forecast

Given the weakness in the global economy and gradual Fed tightening, US corporate earnings will suffer dragging down stock values with them. A corresponding flattening of the yield curve as short term rates rise while long term rates sniff economic weakness and fall. The outlook for the S&P 500 should remain muted ending the year where it started the year, 2050. 10-year Treasuries will remain flat and end the year where they began the year around 2.25% with little catalyst to drive them higher as the Fed moves only impact the short end of the yield curve. Commodities such as oil will be range bound and trade between $20 and $40 ending the year at the higher end of the range as optimism improves as the year comes to a close. Gold will continue to be a safe haven and end the year higher than current levels. Copper will remain range bound as emerging market demand remains soft.