Central bankers seem to be the focus once again. If the global economy were strong enough to stand on its own, we wouldn’t spend every waking moment worrying about what Fed Reserve Chair Janet Yellen and her European Central Bank counterpart Mario Draghi are going to do next. The fact that these bankers are front and center again in investors’ minds, is a function of both how sluggish the global economy is and how persistent the hangover from the mid-2000’s real estate party continues to be.
Europe’s Ills
During the last several weeks, we have received a host of bad economic reports out of Europe. As a result, many investors are focused on a speech Mario Draghi made during the European credit crisis in which he basically said he would do whatever it takes to keep the Euro Zone on solid footing from a financial perspective. That was essentially saying that the central banker would use both interest rate policy and quantitative easing methods including bond purchases to support the banking system and provide stimulus for growth.
Recently, German economic growth was pegged at -0.2% for the second quarter. As the world’s fourth largest economy and a key engine of growth for the Euro Zone, this lack of growth is a concern for European central bankers. In addition, approximately 25% of Germany’s energy resources come from Russia. As a result of the unrest in Ukraine and the West’s desire to impose sanctions on Russia, the cost of energy and those sanctions will be felt significantly in Germany, suggesting that the potential for further deterioration in economic growth rates there is high. Russia issued sanctions of their own on a number of goods including energy and food stuffs which will certainly have an impact on European consumers. Evidence that market participants are presuming an increase in the level of banker stimulus is the decline in the German 10-year Bund which now has a yield below 1%, 1.4% below that of the U.S. 10-year Treasury.
The growth rate for all 18 countries in the Euro Area was 0.9% for the last 12 months. The U.S. growth rate is better than that growing at 2.4% during the last year. In addition to concerns regarding the effects Russian sanctions will have, there is also concern that political instability may make it difficult to maintain a consistent policy across Europe. As recently as this weekend, France’s President Hollande dissolved his government in an effort to improve confidence in his policies which are intended to improve the country’s fiscal situation. Those on the left in France believe that there should be a greater effort made to improve the situation for individuals rather than businesses. This is a common theme across Europe and a function of high unemployment, low wage growth and a slow economy.
Mr. Draghi has some quantitative tools in the policy box but that’s it. Earlier this year, they reduced interest rates as low as possible in order to try to get banks to lend, stimulating the economy. Fortunately, they have not had the same balance sheet expansion that our own Federal Reserve has had but the effectiveness of a quantitative easing policy is still suspect.
European stocks have declined by 5.1% so far this year, according to the MSCI Europe Index. This is in contrast to the broader international markets as measured by the MSCI All Country World Index ex-U.S. which is up 3.8% so far. Our concern is that the cross border sanctions will make a difficult situation more difficult and the export driven economy of Germany, Europe’s engine, will be further hampered for now, negatively affecting equity prices. We believe a reduction in international stocks is warranted as a result of these uncertainties.
U.S. Intervention Continued?
Moving from the Alps to the Tetons, the Federal Reserve hosted its Jackson Hole Wyoming forum for global bank policy makers. Our own Fed Chair, Janet Yellen, reiterated her position that the economic and jobs data is so mixed that some amount of stimulus is required. We know that the quantitative easing that comes in the form of bond purchases is ending this year. In question is whether or not we will see some change in interest rates as well. Current investor sentiment suggests that the first increase won’t happen until mid-2015. However, there are some signs of economic improvement that would suggest a move sooner. As we’ve mentioned in this blog before, however, these signs aren’t so strong as to suggest that the Fed has to move sooner. Some investors have been waving the inflation banner suggesting that it is on the rise. While we’ve seen some increases in inflation, certainly in the energy area, certain food raw materials (farm commodities) such as corn and soy beans, have declined precipitously as a result of a great growing season. Wage inflation has also been rising but the increase has been moderate. We aren’t convinced that the Fed will move any sooner than mid-next year and the bond market seems to be telegraphing their conundrum.
Longer Treasury yields in the U.S. have been declining steadily since the beginning of the year. That has happened despite the Fed reducing their bond purchases by several tens of billions per month since January. Longer dated bond yields are a reflection of investor sentiment regarding economic growth and inflation and currently seem to suggest that neither are a concern. The yield curve has flattened however. This means that short-term interest rates have risen while longer term rates have declined. The 2-year Treasury yield stands near 0.5% up nearly 0.2% since the beginning of the year. This is the place to watch for changes anticipating a significant change in Fed policy going forward.
U.S. stocks have rallied both as a result of this idea that the Fed will continue to be easy with policy as well as because revenue and earnings growth have surprised to the upside. Revenue growth for companies in the S&P 500 Index was nearly 5% during the second quarter. Earnings growth was also stronger than anticipated. As a result of both the Fed and these strong fundamental numbers, stocks have continued to rally and the multiple of earnings that investors are willing to pay has continued to expand. Rising multiples and revenue are a recipe for market strength.
There are some signs that we should be cautious though. The S&P 500 is now up almost 9% since the beginning of the year. Reflecting the dichotomy in the U.S. stock market is the fact that the Dow Jones Industrial average is up less than 3% and the return for the Russell 2000 Index (smaller company stocks) is actually down since the beginning of the year. A market that begins to bifurcate such as this one reflects a transition in investor sentiment that can’t be ignored. While it is possible for stocks to continue to rise, there are reasons to be cautious and we will continue to be positioned so that we are near fully invested however using those managers that focus more on growth at a reasonable price or value.
To be sure, markets are global. Identifying which managers are best at navigating those markets is a key part of our research process. Knowing how the fundamentals shift among global economies is also an important part of how we allocate capital. Understanding what the next move for global central bankers will be is most difficult. What we can do is pay attention to their messaging and imply what affect their changing sentiment may have on asset prices and act accordingly.
Past performance does not guarantee future results and, as with any investment, there is a possibility of loss of principal. You should not assume that an investment in any security, strategy or asset class mentioned in this blog was or will be profitable. The opinions expressed are as of August 25, 2014 and may change as subsequent conditions vary.
