Developed international stocks have been underperforming US stocks over the last few years (up only one third as much as US stocks over the last 5 years) as seen in the graph below. After Mario Draghi and the European Central Bank announced the launch of a bond-buying program in Europe on January 22nd to combat Europe's low inflation rates (more on that later), developed international stocks gained 0.58%, while US stocks sold off -2.05%. Time will tell if the European version of Quantitative Easing (QE) will boost their equity markets like in the US, but is it is a very important change that bears close watching.
The year began with a very good US employment report, confirming that the US added jobs at a strong pace as 2014 closed out. The upwardly revised gain of 353,000 non-farm payroll jobs contributed to a total job gain of 2.9 million for the year, making 2014 the best year for job creation since 1999. The unemployment rate was also stronger than expected, falling from 5.8 per cent to 5.6 per cent in December, getting closer to the Fed's oft-touted "5% unemployment" trigger for ending QE:
Many observers are focusing on the lack of wage growth that comes along with these jobs, as the "average hourly earnings" information in the report was discouraging, decreasing 0.2% (and the same data for November was revised down). Over the last twelve months, average hourly earnings have risen just 1.7%, a real impediment to helping the economy achieve escape velocity. Some refer to this the "hollowing out" of the middle class, and it is sure to be a theme in the 2016 Presidential campaign:
By far the biggest event in January came on the 15th via a surprise decision by the Swiss National Bank to abandon their currency peg of SFr 1.20 to the Euro, while cutting interest rates further from minus .25% to minus .75%. Markets were totally unprepared, and volatility exploded higher. The Swiss Franc immediately soared by 30%, while the Swiss stocks market lost 9%:
By way of background, the Swiss kept their currency independent as the Euro was created but, since many of their trading partners use the Euro, they had to contend with a floating exchange rate that saw the Franc steadily appreciate. Three years ago, their exporters, tired of losing sales, cried "Uncle", and the Swiss announced a "fixed" peg to the Euro, spending untold billions to defend this arbitrary rate while slashing interest rates to negative territory to discourage savers.
With this move, Switzerland just threw in the towel, and now the race to the bottom in currencies has begun in earnest. Japan fired the opening salvo late last year, but now the war has been joined and globalized. The Euro will be the tested in this storm, and it may not survive, having already lost 40% in value from its peak rate versus the US Dollar in 2008. (It's good news though for U.S. travelers - Europe is on sale and likely to get cheaper!)
Coupled with the recent (and continuing) implosion of the Russian ruble, it should be clear by now how the U.S. Dollar is emerging as the big winner (for now) in all this turbulence. International capital is not going to sit still while its purchasing power is cut by 30, 40, or 50 percent. We expect more demand for high quality U.S. stocks and bonds (which still out-yield Japan and the Eurozone by a country mile).
Shortly after the Swiss shocker, the European Central Bank announced its long awaited bid to revitalize the Eurozone economy and counter its persistent deflation with a €60bn-a-month bond-buying program that was much larger than many had expected. In all, the ECB said it will buy more than €1tn in assets, including government, asset-backed, and mortgage bonds, until at least September 2016 (and extending the program if necessary). In short, it was their pledge to do "whatever it takes" to restart the Eurozone.
Germany opposed the decision, but markets took heart and rallied, even though the details revealed that national central banks would assume the losses from any default or restructuring of their national debt (a concession to the Germans, who don't want to bail out France, Italy, Spain etc.) The QE announcement means the end of austerity as prescribed by the Bundesbank, and is a real kick in the teeth to Europe's most powerful economy. Most economic commentators pronounced it an impediment to implementing structural reforms that have long been needed.
Much of this will be moot if the new Greek government makes good on its campaign pledges to walk away (default) on their debt if terms of the country's "assistance" from the ECB cannot be renegotiated. Led by Alexis Tsipras, the far left party Syriza came to power after a decisive vote to reject further austerity measures in late January by the Greek people.
Most investors have forgotten about Greece, and many still view it as a small unimportant country. However, the survival of the Euro is very much at stake, starting now, as Greece will literally run out of money by June if they don't agree to further bailout guarantees, which the people just rejected. There is little ground for compromise, and a very violent reaction is probable if the new government accedes.
So, after lots of hardball negotiations and international posturing to come, there is a good chance that Greece will choose to default, which will expose the sordid underbelly of the European banking system, stuffed full of Greek government bonds. The contagion effect could be tremendous, and no amount of new Euros rolling off the printing press could stop it. In short, investors need to be ready for a very serious credit (bond) event, and a sharp uptick in volatility. 2015 is not going to be a quiet year.
In closing, we're rooting for the ECB's new program to work, but mindful of the real challenges of their "unfederalized" debt and currency. We are certainly living in interesting times! Thanks for reading our Journal, and we'll be back to you next month.