Back on 12th December (in our note titled “Some Dangerous Signals Appear in Financial Markets”, see here, we outlined what we thought were two potential scenarios for 2016. In the note, we said ”…we believe that the best scenario for equities is more of the same seen in the last year or so, i.e. roughly sideways with intermittent bouts of volatility…What is our worst case scenario? A large bear market with the dramatic declines seen this August providing a foretaste of what is to come.”
So far, markets seem to be following our best case scenario. Having declining rapidly during January and early February, markets have embarked on a stellar rally that has brought equity markets to within touching distance of breakeven for the year. When trying to rationalise the 10% rally in equity markets in just four weeks, we would first point to the fact that markets were very oversold and due a sharp rebound. But the driver in recent sessions has to be the cumulative effect of yet more monetary stimulus from major central banks, especially the ECB – of which more below.
As an aside, we struggle to understand a narrative of improving fundamentals in support of the recent market rally. Earnings expectations in the US have collapsed at the fastest pace since 2009, with Q1 2016 forecasts cut from +5% year on year to -8.3% today (see chart 1 below). Over the same period FY2016 earnings forecasts have been cut from +10% to 2.7%. With expectations for the second half barely touched by analysts, we expect full year estimates to drop further as analysts play catch up. With US share prices outperforming earnings yet again, the market continues to re-rate, becoming more and more expensive.
Chart 1 – US Q1 2016 Earnings expectations
Moving on, last week was a big week for Central Banks; no change from Canada, a surprise rate cut from New Zealand and a broad based stimulus programme from the European Central Bank. Unlike December when the ECB over promised and under delivered, the package announced by Mario Draghi was more comprehensive than expected. Without going into the details on what was announced, which have by now been widely covered by numerous commentators, we will consider the market’s response to the post meeting press conference as well as a wider perspective on where we see central banking today.
As is always the case with Mario Draghi nowadays, it is the tone and subtle nuances that come out of his press conferences that seem to matter most. The tone of the prepared remarks were the usual narrative that we have come to expect. Their job is to basically get us to believe that they have everything under control,that they are doing all the right things, and given time everything will be ok. Furthermore, although they admit that their policies are new and therefore experimental, they can control any unintended negative consequences. We therefore need to look to the Q&A for any genuine insight.
In our view, the first questions were planted. The length of the answers and the communication from them tells us a lot about the bigger picture. Here are a couple of quotes;
“From today’s perspective, and taking into account the support of our measures to growth and inflation, we don’t anticipate that it will be necessary to reduce rates further.”
“Does it mean that we can go as negative as we want without having any consequences on the banking system? The answer is no.”
On whether the ECB could have used a tiered deposit rate system to try and push rates further into negative territory, Draghi said “in the end the Governing Council decided not to, exactly for the purpose of not signalling that we can go as low as we want to on this. So the Governing Council, although it gives a positive judgement about the past experience, is increasingly aware of the complexities that this measure entails.”
In Central Banking speak, we don’t think Draghi could have been clearer. Interest rates have finally hit the floor. Throughout the press conference, we think that Draghi gave an air of slight resignation. He has delivered his final comprehensive package of stimulus, and any new measures in the future are likely to be no more that tinkering. To some extent, this view was shared by the market, as equities and bonds sold off after the usual knee-jerk rally, and the Euro strengthened substantially.
Stepping back, we believe that the situation of the ECB being finished with stimulus measures reflects Central Banking generally. Yes, we may see the Bank of Japan tweak interest rates lower in the months ahead, but unless there is a financial market collapse, central banks have no more fire power. This reflects not just where they are, but also the lack of response from the real economy to all the unorthodox policies of recent years, and increasingly, the negative response in the markets and the media to new rounds of stimulus.
All of which brings us back to the central question in markets. Just how much are markets being supported by extremely unorthodox central bank policies, and are they vulnerable to significant losses if investors believe the central banks are now out of ammunition and losing their power to force markets higher. We remain of the opinion that QE and zero or negative rates have done little for the real economy, but have allowed large companies to issue record amounts of debt, partly to finance share buybacks.
The chart below courtesy of Yardeni Research shows the quarterly level of buybacks annualised and the rolling 4 quarter sum. Although the quarterly level has not quite reached the level seen at the last market peak in 2007, the four quarter sum has remained at a high level for well over a year now. This persistence in large buybacks has helped the market levitate in recent quarters. We are not against buybacks per se, but we are against companies leveraging their balance sheets purely to buy back shares. This cannot be good for the remaining shareholders especially when the US suffers its next recession.
Chart 2 – US Share buybacks
We have maintained for some time that the next recession is likely to be devastating for the corporate sector and therefore the equity market, as companies have accumulated debt at an unsustainable rate, as can be seen in the chart 3 below (courtesy of Soc Gen). Not only are current earnings going to struggle to service all this new debt (see the gap between net debt and EBITDA), but a recession will impact earnings to the degree that defaults could rise rapidly. Of course, as defaults rise, companies will be forced to massively curtail their back programmes and in some cases eliminate them.
Chart 3 – US corporate net debt#
So to round up, we feel that central banks are pretty much all in, and increasingly impotent to help either the real economy or the financial markets. The corporate sector is more leveraged than ever before, having wasted resources on buybacks, and have been the only buyer of equities in recent years. The virtuous circle of cheap funding, debt issuance and buybacks is dependent to some degree on investors believing in Central Bank omnipotence. If markets think that central banks are becoming ineffective, then equities are vulnerable to our worst case bear market scenario, which would likely usher in a new recession and therefore impede companies’ ability to borrow to buy back shares.
We view the recent rally as a selling opportunity, and as noted last week, we are now simply trying to finesse our market timing to add to our modest short positions. A renewed risk-off phase will also be reflected in the RMG FX Strategy mandate.
Stewart Richardson
Chief Investment Officer
