Wednesday, December 30, 2015

2016 Market Predictions

It's time to take stock of markets in 2015 and provide our thoughts on where things are headed in 2016. Before we get to the predictions, let's take a look at the consensus view of economists and market mavens heading into 2015 to see what they got right, and what they got wrong.

Consensus forecast for 2015 GDP by economists under a survey conducted by the Philadelphia Federal Reserve Bank at this time last year was for 3.00% growth. This view was confirmed in a similar survey of the Wall Street Journal on January 5, 2015.  Now, with only one day remaining in the year, it looks like 2015 GDP will be closer to 2.00%, a substantial miss. Not surprising, really. In a recent report of Goldman Sachs, researchers found that the consensus forecast for GDP has been wrong in 13 of the past 16 years with economists consistently erring on the side of optimism.

Stock market predictions are equally skewed it turns out. With the S&P 500 wavering on either side of flat for the year, the consensus forecast of stock gurus by CNN Money for 2015 was for a gain of 8% on the year (the index is at 2063 as of this writing, in the red for the year). Nonetheless, stocks still trade at over 19x trailing earnings, a historically high market multiple.

Predictions for the bond market were even further from the mark, with market forecasters expecting a substantial rise in bond yields (and decline in bond prices) for several years now. Yet the UST 10-year currently stands at 2.29% (versus 2.22% this time last year). Hardly the drubbing professionals were expecting. 

This having been said, let's take a look at where things could be headed in 2016.

GDP will likely slow further from its tepid pace of 2015 as the dollar strengths, global demand weakens and oil (as well as other commodities) continue to drag down the energy and materials sectors. With the economy reaching full employment (irrespective of the falling labor participation rate) gains in personal income will likely be limited. While the argument can be made that a low unemployment rate increases the leverage of workers over management, income gains from this source will be far lower than moving people from unemployment to employment, as reflected by a lowered unemployment rate. 

At the same time, consumers continue to be concerned about the economy and their personal levels of savings, as reflected in a rising savings rate. Rising savings with limited income gains spells trouble for retailers and consumer spending more generally. Don't look for any gains in governmental spending either in an election year. At the same time, a strengthening dollar jeopardizes corporate profits and exports. Piece it all together and it's hard to make an argument for rising GDP in 2016.

In this environment, and with stocks at lofty levels, the market will be vulnerable. Against a backdrop of Fed tightening volatility will be inevitable. Profit margins will compress and if p/e multiples contract, the downside for stocks could be pronounced.

US Treasury bonds may present the best opportunity for gain, if the foregoing conclusions about growth and corporate profitability are plausible. With slower growth comes lower inflation, benefiting holders of fixed income instruments. While the Fed may be tinkering at the short end, their ability to control the long-end (absent an unwind of long QE positions) is limited. With a lowered Federal budget deficit forecast for 2016 comes lower Treasury issuance, with an emphasis on the short end, as the Treasury has already so indicated. If there is global turmoil in the year ahead, the fear trade will rush investors into UST, with significant price appreciation a distinct possibility.

Thursday, December 17, 2015

Banks Hike Prime Rate, but leave Savings Rates Untouched

Yesterday, in what must be the most telegraphed increase in interest rates in American history, the Federal Reserve Bank moved to increase interest rates by 0.25%. Major US banks quickly followed suit, hiking the Prime Lending Rate by the same amount. But banks have left the deposit rate paid on consumer savings at close to zero. First reported by ZeroHedge, banks one after the other, including Wells Fargo, Citi, JP Morgan and US Bank moved within minutes of the Fed hike to raise their bank's Prime Lending Rate to borrowers.

What's shocked investors is that after seven years of near zero rates of interest on savings and money market balances at banks, the Fed's long awaited rise in interest rates would have no corresponding increase, not even a comment, on raising the rate of interest for savers on bank deposits. But when you look at how banks have managed the interest rate cycle following the financial crisis, it's really no surprise.

While corporations and banks alike have seen their cost of borrowing fall precipitously following the financial crisis, banks by and large have been unwilling to pass these savings onto consumers through lower interest rates on credit card balances and consumer loans. Banks, who have been able to borrow at interest rates near zero and have paid substantially less than 1% of interest on consumer deposits for the past seven years, have held credit card rates near their all-time high. 

Data of the Board of Governors of the Federal Reserve in a 2012 report to Congress on trends in bank credit card pricing found that average bank rates had fallen from 14.68% in the period leading up to the recession to just 13,09% by 2011. By November of 2014, this rate had fallen to just 12.89%. At the same time, the average rate of return on assets of large US credit card banks had climbed from 2.75% to 5.25%. With the funding cost of banks near zero for this period and the interest rates charged on consumer loan balances stuck at 13%, it's quite shocking that returns on bank assets weren't actually far higher.

This points to the great failure in Federal Reserve monetary policy over the past seven years and why US economic growth isn't far more robust, following seven years of zero interest rates and $4 trillion of bond purchases under the Fed's program of Quantitative Easing. The answer, in short, is that the benefits of easy money and ultra-low interest rates have been retained by the banks, rather than passed along to consumers. With the banks serving as the Fed's only transmission mechanism for monetary policy, this is not only unfortunate, it's unconscionable. 

Thursday, December 10, 2015

Dark Clouds on the Horizon

It's that time of year again when financial markets are dominated by trading for year-end tax purposes, to clean up portfolios and to window dress statements for investors. Volatility is expected. This December certainly hasn't disappointed, with triple digit swings in the DJIA in each of its eight trading days.

But beyond the customary year-end positioning, there's a sense of real trouble brewing in markets for 2016. Here's what concerns us about the economy and financial markets for the New Year:

Plunging Commodity Prices - By mid-year 2015, the Bloomberg Commodities Index fell to a 16 year low, falling to levels below that of the 2009 Great Recession. The Index has since continued its downward spiral through year-end in sectors ranging from oil to natural gas to precious and industrial metals. The plunge in commodities has taken with it resource laden emerging market currencies whose economies and production capabilities had boomed in prior years. The culprit, many suspect is China, having pulled back from its massive infrastructure build of years prior, its financing of still empty cities and its failed attempts to spur internal consumption. Of a scale never quite seen before, in December of 2014 Forbes reported that China had used more concrete in the prior three years than the US used in the entire 20th Century. With the spigot dialing down, demand for raw materials worldwide is plummeting. But our concern is that falling commodities prices bring with them more that just price deflation, but also income, employment and consumption implications, as producers realize substantially less income for the same resources and production expense. A recent New York Times article chronicled the impact of declining commodities here at home upon America's Heartland.

The Collapse of Emerging Markets - Emerging markets currencies have been falling throughout 2015, following devaluations in China and Vietnam and trading weakness in Russia, Turkey, Malaysia and Brazil. The plunge in EM is driven by commodities prices, but also by the high levels of US dollar denominated borrowings in these countries, and borrowers now faced with paying back their loans against a strongly appreciated dollar. But others have questioned whether the ephemeral commodities demand from China is only half the problem. The corollary concern is that ultra-loose monetary policy drove capital to flow into these markets, with that capital now being repatriated as GDP and return prospects for EM countries flounder. Foremost among troubled EM countries is Brazil, once a stalwart of the Emerging Market BRICs, now in a full-scale economic depression. Goldman Sachs believes that a developing crisis in EM is the third wave of the Great Recession; the first being the US housing crisis, the second the European Sovereign Debt Crisis (i.e., Greece, Portugal, Spain, etc.)

Distress in the High Yield Bond Market - Credit spreads in the high yield bond market have been blowing out all year, with CCC rated junk bond prices down 20% from mid-2014.  And bond maven, Jeff Gundlach, head of DoubleLine Capital believes the carnage is about to get a whole lot worse as the markets prepare for liftoff by the Fed.

Weakness in Retail - A slew of third-quarter earnings reports of retail giants Macy's, Nordstrom's and Tiffany's and smaller hot retailers like LuLuLemon, have sent share prices of these companies down 10-20% in a single day following their release of dismal same store sales, top line revenues and earnings. While some of this retail demand may have been made up by online shopping, it's unnerving in what it says about the state of bricks and mortar retail and the US consumer.

Shrinking Corporate Profits - Corporate earnings for 2015 Q4 are estimated to decline -4.3%. If so, it will mark the first three consecutive quarters of year over year earnings declines since 2009 Q3.  A total of 83 companies have issued negative guidance for 2015 Q4. With the S&P 500 currently trading at 17x forward earnings, shares prices could decline amidst falling earnings while still leaving us at historically high valuations. And if both earnings and multiples contract, look out below.

Fed Policy - the 800-pound gorilla of market worries is the Fed, as it prepares to raise interest rates for the first time in ten years. While some believe the impact has been built into the markets, given its long-telegraphed move, concern is growing that implementation may be far more difficult and disruptive to markets that anyone believed.

While there are other concerns looming that bullish investors tend to dismiss, arguing "the market likes to climb a wall of worry", adages aside, investors are wise to take note of what increasingly appears to be a gathering storm.

Tuesday, December 8, 2015

Can the Fed Raise Interest Rates?

With talk in financial markets this month once again focusing on a Fed rate hike, many are wondering, why so much controversy over a mere 0.25% rise in the Fed Funds rate? Viewed from this perspective, it is of course, puzzling. After all, the Fed Funds rate has been pegged to a range of 0-0.25% for seven years. Will a modest rise in the range to 0.25-0.50% even make a difference?

In terms of corporate and consumer borrowing costs, an increase in the Fed Funds rate of this magnitude will do little to slow borrowing and investment. The concern in financial markets, though, is increasingly focused on how the Fed gets there. Even in this topsy-turvy world of the Federal Reserve, the Fed can't simply will it and it will be so. In other words, the Fed will be required to intervene in financial markets to engineer a rate rise, even as small as 0.25%. And given the massive amounts of liquidity it has supplied, this may not be easy.

Fed policy is largely carried out through Open Market Operations: the buying and selling of US treasury securities between the Fed and its universe of primary dealers, typically large Wall Street banks. These banks are required to bid on the sale and purchase of securities at the Fed's request. While the Fed does buy and sell securities directly, as it did to the tune of $4 trillion through its program of Quantitative Easing, its operations are more commonly carried out in the market for repurchase agreements.

Repurchase agreements, or REPOs, involve short-term loans secured by the pledge of US treasury securities as collateral. When the Fed wants to loosen monetary policy, or increase liquidity, it does so by lending to the banks through the REPO market. Banks pledge US treasuries against short term loans from the Fed. The flow of cash (or credits) to the banks, increases liquidity in the banking system.

Now, to drain liquidity and drive the trading range of Fed Funds higher, the Fed does the exact opposite, or as they have imaginatively called it "Reverse REPOs". In reverses, the Fed pledges its collateral against short term borrowings from the banks. The operation serves to drain reserves from the banking system, thereby tightening credit and raising short-term interest rates.

This is all basic to the monetary system. The question that now arises is just how much reverses the Fed must do to get the desired 0.25% effect on the Fed Funds rates. For this, no one really knows. After all, we're through the looking glass on everything that financial markets professionals have learned in business school. This remains the question and that is why markets are so focused on not only when, but how, the Fed will drive interest rates higher.

A Bloomberg article of Sep 16, 2014, estimated the volume of reverse repos necessary to drive interest rates higher at $250 million per day. A hefty chunk of change. But that was a good fifteen months ago. An article in US Today from earlier this year questioned not how much, but whether or not the Fed could raise interest rates. From their report: "Nobody's ever done this before," says Jon Faust, director of the Center for Financial Economics for Johns Hopkins University and special adviser to the Fed's board of governors until last September."  Their argument being, that with $2.5 trillion of excess reserves in the banking system, the Fed has lost the ability to engineer monetary policy with anything less than dramatic intervention in the financial markets. 

But a recent article by the Mises Institute goes even further, questioning whether the Fed even has the tools any longer to effectively raise rates. They highlight Japan's dismal experiment with monetary policy that has now led to sub-1% interest rates for twenty years. One way or the other, it looks like we may soon find out the answer.