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.

Will the 2015 Holidays Bring Markets Cheer?

In the aftermath of the terrorist attacks in Paris on Friday the 13th, equity markets around the globe staged impressive gains on Monday, the first trading day after the attacks. Before the tragic events in Paris, analysts and market pundits had speculated whether markets had it in them to stage a traditional "Santa's" rally this season or if markets had seen most of their gains for the year after the slump in August and September. The question is: Does the market have any more juice?

The Obstacles

History and data seem to reflect market strength during the traditional holiday season, beginning in November. The attacks in Paris represent one obstacle to positive gains this holiday, but what other hurdles must the market overcome to give investors reason to cheer?

Commodities
There seems to be a strong correlation between the price of oil and equity prices. How long will this relationship last? For the time being, weak oil means weak equities. Has oil found a bottom near $40 or will we see further weakness? Because of the correlation with equities market cheerleaders are calling a bottom in oil. So far, they have been wrong on this.
There was a time when copper was fondly referred to as "Doctor" Copper. This was because copper was considered a metric for industrial and manufacturing production because so many items used copper in the manufacturing process. So went copper prices so went markets. This relationship seems to have ended either because it never really carried any real weight or because it stopped suiting the pundits that needed a "story" for the market to rise. Regardless, copper is down 30% this year alone and reflects weak demand from major industrial countries as well as China.
Strong Returns Booked in October
The sell offs in August and September set up October for massive gains, the best month in 4 years. The S&P 500 logged a gain of 8.3% and the Dow Industrials logged a gain of 8.5%. After this impressive comeback many analyst questioned what was left in the tank for the holidays and year end. Some of the Street's biggest bulls are sticking to their early forecasts for further gains but most have trimmed their expectations. The argument is that October pulled traditional late year gains forward.
Weak Fundamentals with Healthy Valuations
Corporate earnings have been coming down raising the overall market's P/E ratio with them. With October's stellar returns the price of the overall market is not cheap and as earnings fall the market gets more and more price. Further gains are challenged by these multiples and no one, even the staunchest bulls, are calling for multiples to expand at this point as the growth required to accompany them is not visible at this point in the cycle.
The Fed's December Meeting
Futures forecast a 70% chance of a Fed rate HIKE in December. This is elevated after a strong October labor report and decent wage gains. The market wants a rate increase but will it rue what it wishes for when it finally comes? Equity gains in the face of rising interest rates is not out of the question, and maybe will come with a sigh of relief, but it's not traditional that equities rally on tightening credit.

Flat 2015

The S&P 500 was flat for the year as of this publishing. Given the headwinds and strong bounce in October, markets will likely end the year near where they currently stand. After the Fed FINALLY raises rates at its December meeting, analysts will try to forecast markets in 2016 and the future path of rates and its effect on equities. There will always be bulls and there will always be bears and the markets will do what they will.

It's Fed Day! The "Will They Won't They?" Will Finally Be Answered

Today, Thursday September 17, 2015, is the final day of the Fed's two day meeting. This has been one of the most anticipated meetings in some time, and for good reason. Although any rate increase will be modest, the shift in policy direction and market perception will be massive, indicating the beginning of the end of easy money policies, and the start of a tightening cycle.

NO FED RATE HIKE

"Won't they!" The Fed decided to hold off on raising the Fed Funds rate at today's meeting. The move would have been more symbolic than material. Any move would have been limited and would only been a statement move that "liftoff" has begun. Today's non-action puts that off for at least another meeting, which is in October.

Was This the Right Decision

"What is the Fed afraid of?" If the U.S. economy is as strong as Yellen repeated it was over and over in her post meeting press conference, what is the Fed obsessing over? According to Yellen's comments, China's economy and market volatility influenced the Fed's decision not to raise rates at this meeting. So has the Fed introduced an additional factor in their decision making process? On the surface it appears that is what they have done. If the Fed has introduced an additional consideration, it complicates the proper equation to make policy decisions going forward. If different metrics can be introduced regarding policy decisions, it makes anticipating Fed moves nearly impossible and hinders the Fed's desire to be more transparent in its decision making process. Unfortunately, the Fed has introduced more uncertainty in to an uncertain environment and market volatility is likely to continue. Now investors get to continue to game the Fed.

If the Market is Always Right, Why are Central Banks Meddling?

One of the first investment lessons about asset markets is that price is king, price is always right. The market will dictate what the price is for an asset. This is a basic tenet of investing in asset markets. The price may be different next year, next week or tomorrow, but today the price is right. This is something all investors agree upon. However, if this is widely held as gospel within the investing community, why are central banks around the developed world waging an unprecedented assault on global asset markets, force-feeding asset prices on markets?

ZIRP and QE

Zero-interest rate policies (ZIRP) and quantitative easing have dominated global central banks for the better part of the last seven years. The US Fed established its Fed funds rate at near zero back in December 2008 and hasn't budged since. In addition to this policy the Fed also implemented quantitative easing, or QE, its asset purchase program to keep longer term rates lower and to inject liquidity in to the marketplace. Both of these policies have been mimicked over the years by various central banks around the globe, some to a lesser extent and others to a greater extent. The latest effort taking place in Europe on  Thursday, September 3rd, where Mario Draghi, the European Central Bank's president, threatened to provide additional stimulus in the wake of the weakening Chinese economy and its potential threat to the Euro Zone's middling economy. The purpose of these policy actions is to manipulate markets. The price of assets are directly affected when the Fed makes a move. But this is normal and happens all the time, right? It is normal and the Fed and Treasury make policy decisions often in hopes to affect markets. That is why they have the ability to make policy changes. If they didn't affect markets, why bother? Although this is all true, it's the extremity and duration of the policies that are twisting markets and not allowing them to function properly.

Dislocations and Misallocations

One of the effects of all the Fed intervention is creating market dislocations. Under normal circumstances, assets price themselves as a function of other assets in the market place. For example, corporate bonds typically price at some function to US treasuries, some spread. Corporate bond prices reflect their inherent risk vs US treasuries through a spread in yield. This spread reflects the premium necessary to adequately compensate investors for the additional risk. During this latest era of easy money, these spreads have been compressed and have not represented the additional risk investors have been taking. This is a problem because it disguises the actual risk that is being taken by the investor, the creditor, and the executive boards of companies that are accessing the capital markets, and creating imbalances.

An additional symptom of the extended current policies is a misallocation of capital resources. Corporations are buying back their own stock and issuing dividends at historic rates. They are doing this financial engineering to prop up stock values and mask the absence of true business expansion through capital expenditures. Companies are not growing so the economy and GDP growth is reflecting this reality, while stock values keep rising. Another misallocation this creates is fund flows from safer investments to riskier investments, often outside of a normal investors risk profile, or better said, the "search for yield." An example of this phenomenon are retirees buying more stocks and less bonds suitable for their normal risk profile, in order to increase revenue.

Pushing On A String: Maybe More Stimulus Is Not the Answer

As Greece faces another default and global markets are mounting a unified "freak out" session, the fact that China's PBOC (Peoples Bank of China) cut rates over the weekend and markets sold off in Asia on Monday, is not getting as much attention as one would anticipate (or maybe that is the real reason markets are selling off and Greece is just a cover story). The ominous inference is that if a rate cut does not have a desired effect of boosting markets, what will? And more ominous, broadly speaking, is the concern over whether central bank stimulus has lost its impact on affecting markets.

Concerted Central Bank Easing

Like good soldiers falling in line, the world's central banks, one after the other, have participated in one of the most orchestrated global stimulus efforts in history. The fact that each central bank seems to have taken its turn at easing is too coincidental to think it was not a concerted effort by governments to stagger their efforts to get a prolonged effect from additional stimulus. This is not to say that there was absolutely no overlap in stimulus programs from different countries but the manner in which the US and Japan followed by the EU announced and implemented their plans appears very coordinated. With global rates at, near or in some cases below zero, new forms of stimulus are required. With the US, Japan and finally the EU implementing their own forms of quantitative easing (QE) that form of stimulus seems to be off the table as an option unless central banks can artfully form a different variety that markets have not seen yet. With governements venturing in to uncharted financial territory they may wonder, why not keep going? Once you've left the reservation what boundaries are you constrained by?

Zero Return World

As central banks have globally reduced interest rates to zero, capital has staged a massive hunt for yield, any yield. The equity markets and junk bond markets have been major beneficiaries of this hunt for yield. Real estate has made its own comeback, as well. Market strategists have justified higher multiples on equities as equivalent returns on corporate debt have declined. In an extreme scenario, corporate debt would yield 1.0% and stock multiples would correspondingly rise to near 100, resulting in near zero asset returns with little to no consideration of risk. In essence, central banks are responsible for creating this environment through their stimulus programs and their unintended consequences. Proponents claim that the recession was not worse because of the Fed's efforts, but that is a lazy defense that cannot be proven or disproven. The most notable impact of stimulus has been its impact on asset prices. The economic recovery has been uneven and on-going for over 7 years. Markets are a discounting mechanism so it is natural that they improve ahead of the data but to date that relationship is out of whack. In this case, the data is way behind the market's performance and is still huffing and puffing to catch up. The result: very low returns across all asset classes. The real barometer of the economy: commodities. Old gauges of a healthy economy, oil demand and copper demand, have declined. Market participants have conveniently disregarded these old markets indicators.

The Proverbial String

Outside of China, central banks cannot force their constituents to borrow, buy and invest. This is the conundrum that the US and the other developed economies face. The labor market has improved but wages are stagnant. Auto sales have stages a huge comeback but it looks like that cycle is about to end with another generation of buyers stuck in extended subprime auto loans sucking up any available consumer discretionary income. This is with interest rates at zero. If things deteriorate from here, what levers does the Fed have? There are no rate cuts left. How does the Fed encourage consumers to borrow going forward? Regulations have left the financial industry hindered and US corporations are more interested in investing in their own stock than to implement capital expenditures plans that would normally create organic economic growth. As these corporations issue debt for financial engineering, the cash remaining on the balance sheets will be needed to retire this debt as rates inevitably rise, eliminating any option for capex spending. This seems to leave the Fed in the precarious position of pushing on a string when and if it needs to battle the next inevitable financial crisis.