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  • European Central Bank in historic rate cut
  • The Fed meets and says more of the same
  • US GDP disappoints

As we wrap up the second quarter of this year, global equity markets and hard assets have led the performance charge. Gold is up 10% this year, while US equities advanced by 7%. Emerging Markets equities have caught up with Developed International stock returns for the year, but both still lag the U.S. Stock Market. Bonds were relatively quiet in June, but are still up a solid 4% year to date:




The three and five year periods of performance have continued to tell a story of U.S. stock market strength outpacing all other major asset classes:  



As the month began, on June 5th the European Central Bank (ECB) cut its deposit rate below zero to -.10%, making it the world's first major central bank to use a negative rate to "stimulate growth". Policy makers also lowered the benchmark rate to 0.15% from 0.25%, diving below the U.S. Fed Funds rate for the first time since the 2008 crisis.


The ECB hopes this radical move will counter the prospect of deflation in the world's second-largest economy, as inflation remains well below their target, and at 50 year lows. For those of us who lived through the mad inflation of the 1970's, it is amazing to see how we have come so full circle, and are now looking at a full-on war against DEFLATION. For a quick primer on this relatively unknown topic, you can go here: 


They also announced that more money would be made available for bank lending, and that a new program to purchase troubled assets from banks was in the works. Unlike the U.S., however, they have not started to buy government bonds (i.e. "quantitative easing"), but they reiterated that they were willing to start such a program if deflation worsened.


Suffice it to say that the ECB is throwing everything but the kitchen sink at the menace of deflation. Can they play the role of "sub-zero" hero? Only time will tell. Almost certainly though, the Euro will decline in value versus the US Dollar and other major currencies, benefitting US dollar markets and assets. For domestic EU investors, high quality European stocks that pay good dividends should benefit, as will their high yield bond sector.


Perversely, this move should also serve to move the perception of "risk-free" assets from sovereign governments to the private sector, where companies are required to be run soundly to survive. The problem of government bond soundness is especially acute in Europe, where they created a common currency, but allowed each of its 18 member countries to issue its own debt, guaranteed by all the others. It would be like having the municipal bonds of all 50 states in the U.S. backed by the U.S. Treasury. Who do you bail out first, and who pays for it? In short, the chickens are coming home to roost in the Eurozone, where massive bailouts have sucked the lifeblood out of their economies, leaving them on the precipice of deflation.


Along these lines, the IMF released a study this month proposing that sovereign bond maturities be "extended" involuntarily in the event of bond markets "closing" to troubled countries (i.e. Greece, a relative financial pygmy, couldn't raise money at any price during the depths of its crisis. Now think about that happening to France, a 900 pound gorilla of the Eurozone). This "re-profiling" operation is another way to confiscate money from investors without giving them a say so (your 2 Year Note just turned into a 30 Year Bond-- good luck selling that when the bond market is in "lock-down" mode). They also propose reducing national debts by confiscating private pension funds (that just happened in Poland as we wrote about last month). Instead of forcing governments to adopt sound financial practices (like everyone in the private sector must do, or fail) these proposals show that the IMF will stop at nothing to keep the current over-indebted system alive, now even explicitly stealing from other savers. It is another reason for investors to dump government bonds and buy stocks. The whole proposal can be accessed here: 


As if to underscore the risk of holding sovereign bonds, Argentina lost a court battle in the US this month that will force them to pay off, at full face value, bonds that were purchased by hedge funds at fire-sale prices. In other words, Argentina wants to pick and choose who to reward for owning their paper. They are oblivious to how markets actually function (i.e. those who step up and bear the risk should reap the rewards.) An imminent default thus looms again for a long time pariah of the bond market who is hard at work cementing their reputation as a serial defaulter for the next generation.


Much of the month of June saw news from Iraq dominating the headlines, as the Sunni insurgent group ISIS re-captured much of the north and west. Oil prices have risen on fears of supply disruptions. The real spike will come if and when Iraqi refineries in the south are captured, and to do that Bagdad would have to fall. Not many folks are betting on that outcome, yet.


It is a distressing situation no matter how you look at it, but especially from the point of view of the U.S. armed forces, who fought so hard and gave so much. Senator Rand Paul and others are clamoring for an isolationist U.S. stance in foreign affairs, and it is likely to gain traction with this outcome, and is certain to be a much more important topic in the 2016 elections.


The U.S. Fed met in June, and again there were no changes to their policies. Another $10 billion a month will be withdrawn from the QE program (less money to buy bonds), and the outlook for inflation is modest for the next three years. They do see a pick-up in GDP growth for the rest of this year, so the surprise would be something stronger. Arguing against this is a sharper uptick in oil prices, which would dampen the economy. The benchmark Brent oil price has been hovering around $115 a barrel, and most observers say that north of $120 will bite into growth. It is a key level to watch.


Just days after the Fed met, US GDP was released on June 25th, and saw a sharp revision downward from -1.0% to -2.9% for the first quarter of 2014 (there goes the Fed forecast for stronger second half growth). Stocks sold off on the news, and bonds rallied, setting a weaker tone going into the dog days of summer:




Lastly, from "page sixteen" of the financial world, the Financial Times reported this month that the US Fed is looking seriously at imposing exit fees on the sale of bond mutual fund shares ("gating") to prevent a potential run by investors. This story highlights the sea change in liquidity that has occurred since the 2008 crisis, as bank dealers have cut back significantly on their inventories of bonds, to as low as 25% of pre-crisis levels. Retail investors operate on the assumption that the daily liquidity they have in their bond fund means the assets that back them are liquid also. That is not always true, especially when "bids" (buyers) disappear, causing "flash crashes", or violent price moves ("gap-downs"). Any rule change would need to be approved by the SEC, but this development needs to be monitored closely, and it indicates how concerned Fed officials are with the prospect of a disorderly flight out of bonds when interest rates finally begin to rise (normalize).


July and August are traditionally "slower" months for investors, as participants take time off for vacation and some R&R. From where we sit, price momentum in all major markets is still quite positive, despite the pessimism that seems to be prevalent. And, while summer markets can be more volatile, it will be a good time to stay invested and remain patient. Bull markets end on waves of euphoria and optimism, which are notably absent today. Les bons temp roulette! 


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