If at First You Don’t Succeed, Try, Try Again

It’s no secret that economic growth has been disappointing.  According to The Bureau of Economic Analysis and the Congressional Budget Office, real per capita GDP growth in the U.S. is averaging 1.3% annually during this recovery (2009-2015).  That is compared to an annual average of 2.7% for recoveries from 1790-2008.  In other words, our current economic recovery is growing at a rate (after adjusting for inflation) that is over 50% below the average rate for the past 200 years.
As we know, considerable efforts have been made to assist economic growth.  The means to that end, from a monetary policy standpoint, has been reducing interest rates and buying bonds.  And everybody is doing it – European Central Bank, Bank of Japan, Peoples Bank of China, Swiss National Bank, and many others.  Amazingly, global central banks have cut interest rates 637 times and have purchased $12.3 trillion worth of assets since March 2008.[i]
Some define insanity as repeating the same thing over and over again and expecting different results.  We’re not sure “insane” describes our central banks’ policy but certainly “unconventional” does.  Collectively they are reading the same playbook and no one is deviating from the script.  This translates into more interest rate cuts.  Furthermore, this is not limited by ZIRP – zero interest rate policy.  The bureaucrats and bankers are so convinced that low interest rates will work that they haven’t stopped at 0%.  Sweden’s Riksbank (the world’s oldest central bank) lowered their main policy rate which was already negative.  The European Central Bank (ECB) and Swiss National Bank have had negative rates for almost a year.  Japan recently joined the gang as the Bank of Japan lowered chief interest to below 0%.  ZIRP has turned in NIRP (negative interest rate policy).
According to Economics 101, lower interest rates are supposed to help the system through providing more money to invest and spend – the stuff that drives the economy.  So if low interest rates are supposed to help, it’s natural to conclude negative interest rates must be even more of a benefit.  As usual, it’s not that easy.
First, negative interest rates are an additional cost to the banking system.  Banks deposit their liquidity at central banks as a matter of convenience as well as safe keeping (central banks don’t go out of business).  In addition to this custodial service, normally the central bank would pay a small interest rate to the depositing bank.  However, under a negative interest rate environment, this is reversed and the service turns into an additional cost – they are charged interest rather than earning it.
Another headwind is that lower interest rates across the yield curve means that banks are receiving less interest from their loans.  Less interest income from loans combined with added costs from increased regulation and having to pay for deposit services equals a squeeze on banks’ margins.  A weaker banking system usually hurts an economy.
Central banks implement a negative interest rate policy to encourage banks to do more loans.  By penalizing banks for keeping too much capital in cash, policymakers hope that lenders will be motivated to do more lending.  However, the ECB has had negative interest rates for almost a year and hasn’t seen much economic improvement.  After six years of cutting interest rates and printing money to buy bonds, the markets seem to be questioning central bank effectiveness.  The emperor may be naked.
Negative rates go beyond bank deposits at their central bank.  More than $8 trillion of high-grade sovereign debt trade at a negative yield.[i]  In other words, investors are more concerned with the safety of the investment than the return on that investment.  They are so worried that they are willing not only give up a return but actually pay someone to take their money.
As for negative rates in the U.S., Fed Chair Janet Yellen was quizzed about it at her recent Congressional testimony.  As expected, her response dismissed that the Fed was considering it.  Recent trader talk, however, has not discharged the possibility.  With some soft economic reports, the Fed is forced, at a minimum, to reconsider the intention of more interest rate increases in 2016.
Turning to the markets, 2016 has been the worst start of any year in history for stocks. In other markets, U.S. Treasury bond yields have declined, gold has moved higher, oil has continued to fall, and the U.S. dollar has been slightly weaker vs. other major currencies.
Despite the stock markets’ ugly start to the year, U.S. markets rebounded last week.  It capped a strong rebound that began on the prior Thursday (the 11th).  After that day, the S&P 500 rose 1% for three consecutive days – October 2011 was the last time this happened.  Another positive was that market breadth was strong.
It was a welcome move after an 11% drop for the S&P to start the year.  The next worst start to the year was 1948’s decline of 9%.  Since 1928 there have been 16 other times where the index started the year down 5% or greater.  The average return for the rest of the year (from that low point) was positive 3.82%.
Volatility has been another noteworthy characteristic of 2016.  The S&P 500 has moved 1% up or down in 21 of the 34 trading days this year (61.8%).  We have to return to the Great Depression to find years with greater moves (1931, 1932, 1933).  Returning to a more stable stock market environment would be a sign of less selling and might be the beginning of a bottoming process.
 
Here are the year-to-date numbers at the end of last week. 
                                           2016YTD
Dow Jones Industrial Average  – 5.9%
S&P 500                                      –  6.2%
Nasdaq Composite                     -10.0%
Russell 2000                                -11.1%                                
Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividends
While the rally in equities was welcome, there were some important blemishes.  The volume on this move was materially less than that of the selloff.  This might indicate a lack of conviction by the bulls.  Furthermore, the best performing stocks during the move were the worst performers going into the bounce.  Also, they were the names with the highest short interest (stocks sold with the expectation of a move lower).
This led many to conclude that last week was an oversold, short covering rally as opposed to a longer term bottom.
Recent economic reports have been mildly ok.  The importance of this is the debate over whether the U.S. is sliding into a recession.  Industrial production, which has a weak point, came in a little better than expected.  And the employment data remains strong.  However, these are backward looking and the recession argument is based on the energy industry’s implosion and several foreign economies that appear to be slowing.
Pessimism and negativity have become pretty widespread across the capital markets.  This could mean that a lot of the worries facing the global economy are already reflected in the current stock, bond, commodity, and currency markets.  However, these obstacles have many uncertainties remaining.  For example, we are only beginning to work through bankruptcies and defaults involving the energy industry.
While it doesn’t look like the fallout will be anywhere near as wide as the sub-prime mortgage problems, it’s unclear who will be the losers and how far the damage travels.
Returning to the central banks, if the markets start to doubt the ECB, BOJ, Fed, et al., it will bring more selling.  This could take the form of acknowledging that the approaches are not working.  Another view is that policymakers are out of ammunition and there is nothing more they can do.  Central bankers have long had critics.  But if global economies don’t start to show signs of significant progress, the number of detractors would grow in size and volume.  This would result in a continued and sizable shift to risk aversion – selling stocks and buying government bonds.
If the markets can hold last week’s moves, it could turn into a base from which further upside could develop.  The drop in stocks and the increase in treasury bonds during 2016 will not likely be reversed in the short-term.  However, stability for the capital markets would be a first step to a widespread recovery.

[i] ibid  [i] The Telegraph, February 15, 2016
Mr. Kerr is an Investment Advisor Representative of advisory services offered through Kildare Asset Management, a Registered Investment Advisor.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Past performance is not indicative of future results. Investing involves risks, including the risk of principal loss. The strategies discussed do not ensure success or guarantee against loss. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. The Dow Jones Industrial Average is a price-weighted index of 30 actively traded blue-chip stocks.  The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. It is not possible to invest directly in an index.  Trading of derivative products such as options, futures or exchange traded funds involves significant risks and it is important to fully understand the risks and consequences involved before investing in these products. All information is believed to be from reliable sources; however we make no representation as to its completeness or accuracy. All economic and performance data is historical and not indicative of future results. Market indices discussed are unmanaged. Investors cannot invest in unmanaged indices. If assistance is needed, the reader is advised to engage the services of a competent professional.
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