|Most asset classes in June had positive returns, despite the volatility spike after the United Kingdom voted to "leave" the European Union on June 23rd (Brexit). U.S. stocks returned 0.3%, while their developed international cousins were off 2.4%. Bonds surged higher on the Brexit news, aided further by the Federal Reserve's decision to put on hold any interest rate hikes in the U.S. near-term. Commodities added heavily to their recent gains, even in the face of a rising U.S. Dollar in June. Gold in particular was solidly higher, with a 9% return in June alone. Investors are again turning to precious metals as a safe place to store cash in a time of high uncertainty in world markets coupled with near zero and even negative yields in bonds.
The last 12 months have told a story of modest returns for U.S. stocks (with elevated risk) and negative returns for stocks internationally (see chart below). Stocks seem to be on pause while global economies and corporations struggle for growth. Commodity prices have also been negative over the last 12 months. Gold has been the exception in the commodity space, returning 12.5% over the last year, the top return of any major asset class. Bonds have also performed surprisingly well, with all categories of bonds showing mid-single digit returns.
As we move into the second half of 2016, the long-awaited turn in commodities looks as though it has arrived, and there are potential gains ahead in corporate earnings growth to finish the year. Many analysts expect these changes in growth trends to be a tailwind for stocks in the second half of 2016. Bonds may have front-loaded much of their gains for the year, with two strong quarters to start 2016. Internationally, stocks look more uncertain as governments sort through the full implications of Brexit.
The month of June will long be regarded as one of the most eventful of the modern era. Not only did we see the beginning of the break-up of the European Union, we also saw new record low yields across major world bond markets.
As the month began, analysts, investors and politicians alike were shocked on Friday June 3 when the Labor Department's official tally of job gains, the Non-Farm Payrolls report (NFP) showed the smallest increase in monthly payrolls since November of 2010, a gain of only +38,000. The talking heads were (momentarily) speechless. Forecasts had been for a reading of +162,000. The report adds to evidence that job growth is slowing, and almost everyone predicted the Fed would hold off on raising interest rates at their June meeting. Shockingly to those who read the fine print (no one even commented on this, to our knowledge), the gains came entirely from part-time jobs - full-time jobs actually shrank in the month of May, for the second month in a row according to the "household survey" portion of the monthly NFP report.
On Wednesday, June 15th, the Federal Reserve voted to keep rates steady, which was widely expected. However, the Fed signaled that markets might still be too complacent about the chances for rate hikes later in the year. While economists don't expect a hike at the next meeting in July, individual members' projections for future policy still point to two hikes this year. Six Fed officials now see just one hike this year, up from just one back in March. Fed Chair Janet Yellen stated in a post-meeting press conference that the United Kingdom's vote whether to leave the European Union later this month ("Brexit") played a factor in the decision to leave rates unchanged.
Before the British vote, a little noticed financial bombshell exploded in Germany in mid-June, as 10 year "Bunds" (Treasury Note) traded below 0% for the first time in almost 200 years:
This follows Japan's breaching of this same critical level in February of this year. To make matters worse, around €334bn of German debt is now yielding in excess of the -0.4 per cent "discount rate" (floor) that the European Central Bank pays banks for excess reserves, according to calculations from Rabobank. That's 60 per cent of the entire German bond market!
This is a very important phenomena for investors to understand. Any bond that does not earn at least -.40% is ineligible for purchase by the ECB under their version of Quantitative Easing. That's around €720.4bn of government paper with maturities between two and 30 years, or more than 11% of the entire market for Eurozone government debt, according to data compiled by Tradeweb. Meanwhile, just under half (46 per cent) of the entire universe of European government debt has now fallen into sub-zero territory, amounting to around €2.8 trillion.
High quality bonds are, in short, "disappearing", and the lower yields go, the less the ECB can do, even as they frantically buy bonds that still qualify, completing a vicious cycle that we'll call "The Negative Yield Trap". Because of this, the ECB is (and will) change the rules as they go: they began buying up corporate debt for the first time this month, causing other investors to bid up prices in hopes that they would beat the ECB to the punch. The effect is the same: Tradeweb data shows €440bn of investment-grade debt has fallen below 0 per cent, around 16 per cent of the entire market, tripling since May. Who can blame high-grade corporate bond issuers like Nestle and Microsoft from opportunistically borrowing billions at effectively no cost? Corporate CFO's must be dancing with glee as free money is theirs for the taking.
Analysts speculate that the ECB may have to cut its deposit rate further from -0.4 per cent, or raise its 33 per cent limit on outstanding bonds for any single issuer. Supply constraints in the sovereign bond market may also push the ECB into alternative assets as well as longer-dated sovereign paper (or anything else they deem acceptable to meet current market realities). In the meantime, positive rates that still exist are under pressure. In the UK after the Brexit news, the Bank of England practically announced a rate cut, after everyone has been leaning to higher rates, just as in the U.S. sentiment changed with the latest employment report. Investors everywhere, especially in the USA, need to get their heads around this negative yield trap. It has produced a shockingly irrational risk/reward relationship in vast swathes of the global bond market. It is the "bubble" of our time, and when it unwinds, it will sink many portfolios. Forewarned is forearmed, as they say.
On June 23rd, voters in the UK stunned the world by voting to "Leave" the European Union. In an act of bravado rarely seen in the modern world, rank and file citizens rebuked the establishment political class and elected to control their political and economic destiny locally, rather than sacrificing their sovereignty (and currency) to an un-elected and anti-democratic European Parliament.
The decision shocked financial market participants, triggering a wave of volatility in capital markets around the globe that hasn't been seen since Standard & Poor's stripped the U.S. of its 'AAA' rating in August 2011. The dollar soared as the pound sterling sank to a 30-year low, sovereign bond yields plunged in a flight-to-safety trade, oil prices dropped, and global equity markets were pummeled, collectively losing more than $3 trillion in market capitalization in just two days. The S&P 500 fell 113 points, or 5.3%, in the two days following the stunning Brexit vote. (Just as remarkable, nearly the entirety of that loss was recouped in the next three trading sessions.)
It is hard to over-state the importance of the "Brexit" vote. Many immediately rushed to downgrade their opinion about the outlook for the UK economy. Certainly it will take time for all to adjust to the new reality, and uncertainty will persist (but what else is new in investing?). In our book, the British, by their bold action, will be able to side-step what is increasingly looking like the utter meltdown of core Europe.
We'll address this theme in future Investment Journals, but suffice it to say that the political upheaval coming this fall to the USA will have its full expression next spring in France and Germany, both of which have federal elections which should see a complete housecleaning of career politicians. Angela Merkel, whose decision to allow unlimited immigration of refugees to Germany (and thus all of Europe due to EU "free travel" rules) is in a prime position for the coming casualty list. Her feckless act (taken without consultation with other EU member states) will be seen by historians as the opening salvo in the death of Europe, and it has alienated everyone, including her countrymen, who put her approval rating below 50% for the first time she was appointed Chancellor in 2005.
The unworkable economic union that has always been Europe has now been joined by a toxic political brew sparked by mass immigration that will soon see a wave of other countries voting to leave the EU. In short, chaos is coming to Europe, all due to establishment politicians who can't see the forest (the will of the people) for the trees (their permanent myopia resulting from a lifetime in politics). As we've pointed out before, the US dollar and US equity markets will be prime beneficiaries of the coming turmoil, as capital flees to safer shores.
To illustrate the point, the chart below is of Italy's third largest (and the world's oldest) bank, Banca Monte Dei Paschi di Siena:
From a high of over €88 per share, today's price is just €0.27, a loss of over 99%! (And that's with one giant infusion of public money already under its belt.) Lost in the noise of Brexit, the Italian government has just come hat in hand to the EU, asking for yet another bailout. And there are scores of banks in Europe whose stock chart looks just like this, whose balance sheets are stuffed with billions of bad loans. Why would any global investor want to keep their money in Euros with this kind of "capital destruction" going on? As we saw with the pound, currency volatility is rising dramatically, as capital re-positions itself globally. The euro is in the crosshairs. Conditions are ripe for a mass exodus. The twist this time is that negative interest rates in Europe (described above) will exacerbate the flows, so when the dam breaks, it won't be a flood but a tsunami!
Finally, June did close on an upbeat note, as national U.S. manufacturing grew at the fastest pace in over a year according to the Institute for Supply Management (ISM) manufacturing index, which jumped to 53.2% in June from 51.3%. The ISM reading is back to its highest level since February of 2015. U.S. manufacturers are on their fourth straight month of growth following five months of negative readings (which was the weakest stretch since the Great Recession). Companies have benefitted from recent mild weakness in the value of the U.S. dollar, which makes their goods cheaper overseas. The ISM new orders gauge also increased to a 3-month high of 57% in June, up +1.3% from May. The ISM report agreed with the Purchasing Managers Index (PMI) of national manufacturing conditions, which also hit a 3-month high in June, rising to 51.3 from 50.7.
As we look ahead to July (and finish up our Journal), a new milestone was reported as the 50 year Swiss Government Bond traded below 0% for the first time in history on July 5th, meaning the ENTIRE Swiss yield curve is negative:
On the same day, the 10 year US Treasury Note also traded at an all-time low record yield of 1.37%. What a way to begin the third quarter! We'll be watching to see if this trend continues this month. Meanwhile, get ready to refinance if you have a home mortgage above 4% - we wouldn't be surprised to see rates move below 3% soon!
Investors in July will also be focused like a laser on second quarter earnings. After four straight quarters of a year-over-year decline in quarterly earnings, and six straight quarters of a year-over-year decline in quarterly revenue growth, any positive light at the end of the tunnel could send equities higher.
Have a great month, and thanks for reading our Journal!
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