- Expect the ECB to do something in June, but not QE
- Ukraine is the top geopolitical risk
- Rotation into defensive names in the US is worrying
- China is exporting deflation
- Easy money is causing a reaching for yield
Yesterday, the euro rallied to near 1.40 after the ECB’s announcement that it would leave interest rates unchanged. But, the euro fell nearly one big figure after Mario Draghi hinted that in the next meeting in June the ECB would be prepared to take some accommodative action to work against deflation. He did not specify what precisely the ECB would do. However, his comments inspired confidence that the ECB would do something.
From Draghi’s remarks, it was clear, however, that all the calls from the OECD, IMF head Lagarde and from politicians in France and elsewhere to do QE or to impose negative reserve rates were viewed as political interference. Draghi made it seem that this weakened the ECB’s credibility and put its independence in doubt. I am not sure whether he was making an observation or whether he was suggesting the ECB needed to act to show it had maintained its independence. The market is inferring the former because the latter interpretation would mean no adjustment in June.
My sense here is that Draghi wants to ease in some capacity but is still in the throes of getting consensus around what kind of easing is appropriate. I imagine the Germans in particular take umbrage at all the political pressure on the ECB. And so Draghi’s comments were a way of backing them publicly so that he could get them on side to ease by June.
I still don’t see QE for quite some time because of the difficulties that the ECB would have regarding article 123. But I do think that we could see a rate drop or a negative rate on reserve deposits, though both of those policies will have zero affect on credit to Eurozone SMEs and business in the periphery, which is where credit is lacking.
In terms of global risk, three things come to mind. First, the building civil war in Ukraine and the attempted isolation of Russia by the US is a big problem. Reuters is reporting that German magazine Stern estimates that Russia sanctions could hammer German growth, reducing GDP growth by up to 0.9% this year. In that vein, German business has urged a halt to sanctions against Russia, putting Chancellor Merkel in an awkward situation as an American ally.
Second, the US markets are showing a very worrying irregular pattern with momentum stocks like Tesla and Twitter getting hammered. There seems to be a rotation into defensive stocks, an event which is usually negative for equity valuations. Market breadth is weakening. For example, only 7.2% of S&P 500 stocks set new 52-week highs on Wednesday and only 10% did on 2 April, the last time the S&P closed at a record. That compares negatively with a high of 39% reaching a 52-week high a year ago.
The blue chip Dow Jones Industrial Average is doing best (graphic here), while the broader S&P is also holding up. But the Nasdaq is down, with a wedge pattern developing (see graphic here) to give some support. Meanwhile the Russell 2000 is in a downward channel that looks problematic (graphic here). Christopher Wood, who chronicled “The Bubble Economy” in Japan two decades ago, has a base case in which the rest of the market follows the Internet stocks down. He told Bloomberg Television, “you could be getting your biggest correction in the S&P since 2011.” In 2011, the S&P dipped 19%, just short of the 20% considered a bear market until QE came to the rescue.
Note that some of this could be technical. The Wall Street Journal reports:
A record-setting amount of share buybacks and dividend increases in 2013 helped propel the stock market to new highs. But investors have been less willing to reward such shareholder-friendly initiatives this year. That has kept a lid on the market’s performance and could make companies think twice about implementing bigger buybacks in the future.
Without buybacks to fuel earnings growth, perhaps this is why we are seeing the rotation into defensive names.
Third, as always we have the Chinese slowdown. The emerging markets crisis is completely off the radar screen now because the panic of January and February has gone away. Wood even thinks EM equities, having been beaten up, are the place to go. But with China still rebalancing, we have to expect that growth deceleration to have a disinflationary impact on global growth, especially in commodity-exporting countries. Chinese inflation came in below expectations today, with the consumer price index up 1.8% year-on-year through April. The producer price index fell for the 26th straight month, down 2.0% year-on-year. That means China is exporting deflation to the rest of the world now. And this will have a negative impact on global GDP growth. For further reading on China, I recommend Michael Pettis’s piece on the Chinese currency issue and the Reuters piece on the building glut of residential property.
Going back to the thesis of yesterday’s post on reaching for yield, despite the Shiller P/E at dangerous levels, my biggest concern is credit markets. Again, when real yields are negative and nominal yields low, you are creating distortions because investors have expectations both in real and nominal terms that are not being satisfied. And that means they have to reach for yield. We are seeing the same kind of dodgy lending and underwriting we saw pre-crisis: originate to distribute, PIK preferred debt instead of interest payments, covenant light loans, an increase in subprime and high yield debt as a percentage of the overall market, etc, etc. Right now, default rates are low but they are counter-cyclical, meaning they skyrocket as the cycle turns down. And while US foreclosure rates are falling, we are already seeing an uptick in default rates for high yield debt and for subprime auto borrowers in the US.
I ended yesterday’s note asking whether we are going to see Europe move into the yield-reaching mode that we see in the US. And I think we have seen this already in sovereign credit. For example, junk-rated Portuguese 10-year bonds are yielding less than triple-A rated Australian ones. Irish 10-year bonds are now yielding less than British 10-year bonds. All sorts of risky carry trades are likely to emanate from the convergence in sovereign debt in the eurozone. And of course these bets will end badly.
There is froth in Europe’s credit markets elsewhere though. Take a look at this piece based on Citi analyst Matt Kings piece about the urge to merge meets the dash for trash. It’s good. And then there is the clamour for high yield in Europe as reported by IFR:
European high-yield investors eager for diversification are crying out for riskier credits and structures, to move away from a market that has become dominated by bank debt refinancing deals.
Bottom line here: When rates are held artificially low, this is what we see. All of these policies, low nominal rates, QE, and negative deposit rates, are all an outgrowth of a loose monetary, tighter fiscal paradigm that is not working. And it is not at all helping ease credit conditions where the easing is needed – with small and medium-business, households and peripheral business. So easy money is failed economic policy that will end up making the eventual credit downturn worse. Easy money feels good but eventually ends in credit writedowns and financial crisis.