Tail of the Put
Financial Review by Sinclair Noe for 12-30-2015
DOW – 117 = 17,603
SPX – 15 = 2063
NAS – 42 = 5065
10 Y – .01 = 2.30%
OIL – 1.07 = 36.80
GOLD – 7.90 = 1062.10
I was away on vacation on December 16th when the Fed raised interest rates, so I want to start today by going back and taking a look at what that really means and how it might affect the economy and the markets moving into the New Year. First, let’s be clear; the Fed did not raise rates on December 16th; the Fed raised their target for the fed funds rate, which is the rate at which banks lend to each other. That’s a technicality. The Fed will buy and sell securities to increase the cost of borrowing money across the banking system. So money is becoming more expensive for all financial institutions. And the banks and financial institutions then pass along those cost to their customers in the form of higher interest rates. Short-term and long-term rates will move higher, at least in theory, but in reality, they don’t always move higher in lockstep.
And the dollar should get even stronger as rates move higher on Treasuries and corporate bonds. The reason is simple; if you are a foreign investor and you want to buy debt that offers a higher rate you first have to trade whatever currency you have for dollars to make the purchase; that raises demand for the dollar causing the price of the dollar to go up or get stronger. Also, many investors will take money from stocks to buy bonds that offer a higher rate, so money tends to flow out of the stock market. Higher rates mean savers should get more return on their saving, but higher rates also mean borrowers face higher debt service; in other words, mortgages, auto loans and credit card debt will all cost more. Again, not everything moves in lockstep, so the banks tend to raise their lending rates quickly but they are slow to raise the rates they pay out on deposits.
And because the cost of borrowing goes up, consumers tend to spend less, at least for purchases that involve borrowing. And if people buy less, the companies that make the goods or provide the services tend to cut back and invest less on expanding their businesses or hiring new workers. Again, it doesn’t always play out in a clear, linear pattern; the US economy has changed, and the service sector is about 3 times larger than the manufacturing sector. You might need to take out a loan to buy a car but you pay cash for a hamburger, so rate hikes may have less impact on the labor market than in the past.
And while a slowing economy is bad for households and businesses, the Fed doesn’t want to stop economic growth, merely slow it down just a little to avoid inflation. The Fed thinks inflation should be about 2% – a nice safe speed that allows the economy to move forward safely. If the Fed moves too far they risk slamming on the brakes, people buy less, as demand drops, companies cut back and can’t raise prices, workers are in a worse position to demand higher wages; and the overall effect can be deflationary. So hiking interest rates is tricky and dangerous for the economy, for businesses, for the stock market, and for individual savers and investors. And the reality is that the Fed does not have a great track record of raising rates without something going wrong and sending the economy into a spin. This should be the over-riding theme for investors to watch in 2016.
The whole reason for a Fed rate hike is questionable since there are few signs of inflation to worry about right now. One area that has kept prices low is the low price of oil, which could change in a heartbeat, but for now shows no sign of moving outside the $30 to $50 range per barrel.
Crude oil prices dropped today as Saudi Arabia announced it will not limit production, and the American Petroleum Institute said its estimates show U.S. crude stocks likely grew by 2.9 million barrels in the week ended Dec. 25. West Texas Intermediate futures are heading for their biggest-ever two-year drop, while the Standard & Poor’s Energy Sector Index is set to mark its first consecutive decline since 2002.
Beyond the commodity markets and the energy sector, 2015 has been a really flat year for most financial assets. The S&P 500 is on track to close the year at the same level we started, give or take a fraction of a percent; add in reinvested dividends and the S&P will likely deliver about 2% total returns for the past 12 months. Intermediate term Treasury bonds will deliver a 12 month return of about 1%. Not quite the stuff of champagne wishes and caviar dreams, but better than the riskier areas of junk bonds, which dropped 7% for the year, or emerging market stocks, which lost 14.5% on the year.
So after 5 years of one of the strongest bull markets in our history, 2015 was probably disappointing for most investors. Don’t feel bad. Even the best investors stumbled this year. The Oracle of Omaha is headed for his worst year relative to the rest of the U.S. stock market since 2009, with shares in Berkshire Hathaway down 11% with just two more trading sessions to go. What’s been eating at the stock? While the company doesn’t have oil and gas subsidiaries, its railroad business transports oil, coal and agricultural products, and its manufacturing arm sells products to the shrinking oil industry. Berkshire has also been hit by big declines in two of its largest investments: American Express (-24%) and IBM (-13%) YTD.
The markets are getting less fuel from the Federal Reserve’s easy money policies, and now have to rely more on fundamentals. Companies will need to produce actual profits, rather than financial engineering tricks like stock buybacks. Between 2009 and the end of 2014, you could look at a chart of the S&P 500 and it was nearly identical with a chart of the Fed’s balance sheet. Fed monetary policy provided an easy path to corporate growth without the need to actually grow profits, while at the same time pushing investors to take on more and more risk. This is a carryover of the Greenspan Fed and the idea that stock market wealth would trickle down to the broader economy in the absence of real economic growth; it didn’t turn out that way and Greenspan even admitted the failure. The easy money went to Wall Street and never trickled down to Main Street.
Part of the problem is that the Greenspan Put placed inordinate importance on the role of financial assets in the economy, and forgot the truth on the ground that the way to make something is to actually make something, not just shuffle paper and slough off risk. Now it looks like Yellen would like to amputate that vestigial tail of the Greenspan Put, but her plan is to do so gradually and incrementally, slowly inching rates higher over the next two or three years. But gradualism has a poor track record. The incremental rate hikes of 2004 to 2006 followed the extraordinary accommodation of 2001 to 2003; it did not reign in the market speculation but instead lead to the financial crisis of 2008. Wall Street tends to throw a tantrum when the free money spigot is closed. Rather than supporting productive economic activity, gradualism allowed Wall Street financiers time to figure out how to create greater and greater risk, and then sell it off to the greater fool.
Time will tell if 2015 was just a pause or a breather in a marathon bull market, or whether this was the year that the Fed tapped the brakes and everything just came to a slow grinding halt.
The IMF says 2016 growth will be “disappointing and uneven.” International Monetary Fund head Christine Lagarde says, “In many countries the financial sector still has weaknesses and in emerging markets the financial risks are increasing,” and “All of that means global growth will be disappointing and uneven in 2016.” Lagarde pointed to the lingering effects of the global financial crisis as well as low productivity and unfavorable demographics as reasons for the disappointment.
Puerto Rico will default on some of its bonds. Puerto Rico and its agencies owe nearly $1 billion in interest payments Friday, including $357 million on general-obligation debt that the Puerto Rican constitution says must be paid before everything else. Gov. Alejandro García Padilla said the government could not pay about $37 billion on revenue bonds due on Friday, clawing money from one set of bonds to pay debt on another, and essentially resulting in default on roughly $163 million in debt.
Bank of America will take a write-down on its Merrill Lynch securities. Bloomberg reports that Bank of America will take a $600 million write-down in the fourth quarter. The write-down will be related to the coming redemption of Bank of America’s $2 billion worth of trust-preferred securities stemming from its Merrill Lynch acquisition back in 2009. The securities will no longer count toward regulatory capital starting in 2016.
Julius Baer, one of a dozen Swiss banks to come under U.S. investigation for helping American clients dodge taxes, has set aside another $200 million to settle the probe, bringing the total amount earmarked to cover potential penalties to $547 million. Despite the charge, Julius Baer said it expects to report an adjusted net profit for the current year.