Best of 2016: Flat Markets and Negative Rates
By market history standards, 2016 was a pretty mundane year. Although conditions were occasionally choppy, for the most part the markets stayed flat.
Don’t let that fool you though. As always, there is more beneath the surface.
The S&P 500 ended 2015 at 2044, and remained flat throughout 2016, until the rally following the surprise victory of Donald Trump in the US presidential election, when it jumped to where it currently hovers, at around 2250, for a 10% year-to-date gain. In Europe, the STOXX 600 began 2016 at 366, and as of this writing, is hovering at 359, for a small loss of under 2%. The Nikkei opened the year at just over 19,000 and is presently trading near 19,300, for a gain of just over 1%. Meanwhile, in China, the Shanghai Composite Index commenced 2016 at 3539 and is currently at 3117 — a loss of nearly 12%.
Yet the EPS of the S&P 500 has declined. After peaking at $105.96 in September 2014, EPS has declined to $89.10 — a drop of 16%. Surprisingly, the S&P 500 is at an all-time high. As of the third quarter 2016, revenues for European companies were down 4.3%, while earnings for the second quarter had fallen 14%. Likewise, European stocks levitated. Corporate profits in Japan were down three consecutive quarters through 30 June 2016, rising 11% in the third quarter.
Oddly, though company profits lagged, the markets showed no such weakness. Such is the central bank-dependent world in which we live. Stock markets are driven by central bank policy. Earnings increase, stocks increase. Earnings decrease, stocks increase . . . because the market expects more quantitative easing (QE). Heads I win. Tails I win. Not bad. But doesn’t this concern anyone?
The regime change that commenced with the US Federal Reserve’s 0.25% rate hike in December 2015 continued with another 0.25% boost in December 2016. The prospect of rising rates has given many investors pause. But to be clear, there is a big difference between the cessation of QE and mopping up liquidity. Thus far, we have only experienced cessation in the United States, or tapering in Europe, with the periodic threat of a resumption of QE. Raising rates will do little to unwind the massive QE pumped into the system.
But all this bond buying and stimulus has come with a price — zero or, in many cases, negative interest rates. In fact, the central bankers’ ongoing romance with negative interest rates is perhaps the most important story of 2016.
The world turned upside down on 11 June 2014, when the European Central Bank (ECB) administered negative interest rates at -0.10%. Rather than demanding that the central bank pay interest to borrow its money, banks now had to pay the central bank to lend it money. Over time, the ECB plunged rates even further into negative territory. By March 2016, deposit rates were down to -0.40%.
Negative rates grew widespread in Europe, reaching Germany, Denmark, Sweden, and Switzerland. In fact, Switzerland has maintained a target rate of -0.75% for some time. Similarly, the Bank of Japan (BOJ) began charging interest to deposit funds at a rate of -0.10% in January 2016, continuing that trend throughout the year.
As for 10-year government bonds, Germany’s opened the year yielding 0.63%, falling steadily to -0.19% by July, and rallying somewhat to finish the year in the positive column at about 0.36%.
Japan followed the same path. Ten-year Japanese government bonds (JGBs) began 2016 at 0.26%, dipped to a low of -0.29% mid-year, only to recover to 0.09% at the time of this writing.
In Switzerland, the 10-year bond yield started the year at -0.06%, fell to -0.63%, and also rebounded with the latest yield at -0.07% — essentially where it started. Much of that recovery occurred in the wake of Trump’s victory in early November.
In fact, since the election, the bond and stock markets have moved in opposite directions, albeit briefly. Stock prices went up and bond prices went down while yields increased. Have stock and bonds resumed their roles as countervailing forces? That’s not clear. What is clear is that stock valuations are now in elevated territory.
The Wilshire 5000 — the 5000 largest US companies by market cap — divided by GDP is at 120%, compared to an historical average of about 80%. Offsetting this valuation is Trump’s plan to cut taxes at both the consumer and corporate levels. Whether or not he will be successful and to what degree remains to be seen. Given his surprise election, it appears the markets are grappling with these questions.
Of course, this doesn’t explain market valuations elsewhere. Japan’s market cap has languished at around 100% of GDP — well above its historical average — for years. In contrast, eurozone stocks are trading at a ratio of about .51 market cap to GDP. This is the approximate historical average. Of course, interest rate conditions strongly influence the multiples the market is willing to bear.
So, the ultimate questions are: Will the central banks be able to keep markets stable as the Fed tries to lift rates? Or will the markets erupt and force the central bank to dial rates back down towards zero?
The year 2017 should give us that answer.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image credit: CFA Institute