Global Interest Rate Policies

January has to be the odds-on favorite for the longest month of the year. It’s the coldest month of the year. It inevitably starts off with a “let down” for most of us as it comes right on the heels of the bustling holiday season. And as one of seven months on our calendars with 31 days no other month can claim to be longer, but January feels the longest for more reasons than just that. Fans of January offer the rebuttal that the month provides an opportunity to start anew. They also sometimes point out that the stock market outperforms in January, on average. Well, that may be true “on average”, and global markets did stage a strong rally on the last trading day of the month, but it still wasn’t enough to pull January 2016 into the green. Not by a long shot.

In last month’s blog, we noted that 2015 hadn’t been great for investors. Most asset classes – stocks, bonds, commodities – were down for the year. Global growth slowed last year, and the oil market got hammered. The only thing that seemed to be up was volatility and a heightened sense of pessimism. The Fed’s handling of interest rates may be responsible for much of the volatility now saturating asset markets. Keeping short-term rates essentially at zero for seven years was an unprecedented monetary policy that produced a number of unintended consequences. For example, ultra-low rates had a huge influence on investor decision-making and, by extension, asset valuations. Conservative bond investors, desperate for yield income, moved farther out on the risk curve, which helped to bid up stock prices. This has been the case particularly for growth stocks, which are in greater demand when economic growth is low.

COMMODITIES

Commodities prices are largely indicative of the global growth slowdown as the slide in commodity prices that began in 2011 shows almost no signs of slowing this year. Commodities prices have fallen to their lowest level since 2003, thanks in large part to the slowdown in China’s industrial sector, unexpected resiliency in U.S. shale production, and the strength in the dollar. U.S. crude oil prices fell more than 9% in January alone, but have bounced off a more-than-12-year low seen earlier in the month. The price of gold rose 5.3% in January, its largest monthly gain in a year, to $1,116.40 a troy ounce.

MONETARY POLICY

Central banks around the world, including the U.S.’s Federal Reserve, continue to implement extraordinary policy measures in an effort to stimulate growth in their respective economies. While the Fed left interest rates unchanged in January, a move that was expected, it expressed an increasingly cautious assessment of the global economy, which gave investors more reason to worry. Last December, the Fed decided to raise rates for the first time in nearly a decade, citing a healthy labor market and other signs of steady economic growth at the time. It had to be the most agonized-over 25 basis point (one-quarter of one percent) interest rate hike in the history of central banking. The Fed signaled an increasing concern over falling energy prices and a slowing global economy and reassured the markets that its decisions would continue to depend on the economic environment realities of the time.

Foreign central banks continue to diverge in policy from the Fed. At month’s end, the Bank of Japan (BOJ) announced that it was adopting a negative interest-rate policy, a move that shocked the markets. The decision was the latest in a string of central-bank actions. Earlier in January, China’s central bank injected cash into the financial system, and the European Central Bank (ECB) suggested it could provide more stimulus for the Eurozone as early as March. The BOJ’s decision to join the ECB and the central banks of Sweden, Denmark and Switzerland in negative interest-rate territory would have been virtually unthinkable before the financial crisis, but it’s increasingly common now.

CURRENCIES

Negative borrowing costs may send money flowing out of Japan and into the U.S., where rates on assets priced in U.S. dollars are broadly expected to rise in coming years. That stands in contrast to many other economies around the globe where currencies are weakening, interest rates are falling, and central banks are expanding exceptional policy easing. This divergence has been in place for the better part of two years, fueling a rise of more than 20% in the U.S. dollar against a basket of the currencies of its major trading partners. A new burst of dollar strength may not bode well for the U.S. economy. S&P 500 companies rely on international markets for more than a third of their profits. A mightier greenback makes U.S. exports more expensive, and it diminishes the dollar value of overseas operations.

U.S. ECONOMY

The U.S. economy sputtered as it entered 2016, weighed down by global headwinds that dented business investment and exports. The Commerce Department reported recently that U.S. gross domestic product (GDP) expanded at a 0.7% seasonally adjusted annualized rate in the fourth quarter. The economy had advanced 2% in the third quarter and 3.9% in the second, so it’s obvious the U.S. economy is decelerating.

The recent slowdown reflects an array of crosscurrents. Steady job gains, an improving housing market and banner auto sales helped underpin growth through much of the year. Spending on residential investment, such as new home construction and home remodeling, advanced 8.1% in the fourth quarter, and the housing market in 2015 was by some measures the strongest since before the recession. Also, the U.S. consumer may be regaining his footing, which is welcome news. Personal consumption, which accounts for more than two-thirds of economic output, rose 2.2% in the fourth quarter, and full-year consumer spending in 2015 advanced 3.1%, the fastest pace since 2005. However business spending did not follow suit. Non-residential fixed investment, a measure of business spending, declined 1.8% in the fourth quarter as companies trimmed outlays. Businesses also exported fewer goods and trimmed back inventories at the end of 2015. The economic slowdown in China and persistent weakness in Europe appears to have been a drag on many U.S. companies.

STOCKS

It has been hard trying to find much logic in the price action of the world’s stock markets so far in 2016. The only constant has been market volatility, with emotional investors ready to shed risk assets at the slightest whiff of bad news. The S&P 500 lost 5.1% for the month, and that was after world markets staged a strong rally on the month’s final trading day, when markets surged on news that Japan was lowering rates. Foreign developed stock markets suffered losses in line with those felt in the U.S. markets, while emerging stock markets faired far worse. China’s Shanghai Composite index is down more than 22% so far this year. The less volatile Hang Seng index is off less, down 10% this year. The MSCI All Country World Index was down -5.3% in January. In the U.S., daily stock-trading volumes were elevated during the month, with the most shares changing hands since August 2011. This all capped a turbulent month for financial markets in which investors fled from stocks and flooded into haven assets such as government bonds and gold.

Money continued to flow steadily out of U.S. stock funds during the month, reflecting a lack of confidence in the equities market. The U.S. stock market is at least fairly valued, with the forward 12-month price-to-earnings ratio (P/E) currently at 15.6, which is above the 5-year and 10-year averages of 14.3 and 14.2, respectively. Any significant appreciation in stock prices from here will need to be a function of underlying earnings.

EARNINGS

U.S. earnings news has been mixed. Blended earnings for the fourth quarter of 2015 are down -6.0%. If final earnings for the quarter show a decline, it will be the first three consecutive quarters of year-over-year declines since 2009. Numbers from energy and materials are hurting the overall averages, but there’s a pattern of companies delivering on their earnings per share (EPS) expectations, but missing the mark on sales estimates. Comments from companies show a pattern – the negative impact of slower global economic growth and a stronger U.S. dollar are for now overwhelming the expected positive net impact of lower oil and gas prices.

BONDS

With all of the gyrations and fear in the stock market in January, it was no surprise that money poured into bonds during the month, boosting prices and pressuring yields. The Barclays U.S. Aggregate Bond Index was up +1.2%, and the yield on the U.S. 10-year Treasury note fell more than a third of a percentage point for the month – a large gap down in the bond world. At month’s end, the U.S 10-year Treasury note was yielding 1.928%. A yield on the 10-year below 2% is widely associated with economic distress, so apparently lots of bond buyers have big concerns about the state of the U.S. and other economies.

SUMMARY

Most market followers didn’t have great expectations for 2016 as the year commenced. Well, so far their doubts have been confirmed. Stocks have continued to suffer, and oil’s price collapse has continued. Global growth forecasts are being trimmed further. This makes it even harder on central bankers who have already pushed the limits of creative monetary policy. Japan is a case in point. The world’s third-largest economy has pulled out almost all the stops, including a move to negative interest rates, to pull out of its deflationary slump and still has yet to see persistent growth or inflation.

Asset allocation and diversification struggled last year, but both disciplines helped in January. Bonds outperformed stocks for the month, so while January was a negative month for risk assets like stocks and commodities, conservative strategies that included exposure to bonds lost less.