Could the stock market be headed for a huge fall now that central banks are removing stimulus measures?

Jerome Powell
Fed Chair Jerome Powell speaks in the Rose Garden shortly after his nomination in November, 2017

In the wake of the financial crisis over 10 years ago, the world’s largest economies were left in a precarious situation. Low growth, hampered investor sentiment, lower spending and high unemployment all combined to create an economic malaise which forced central banks to act, in an effort to stimulate the ailing economies which they served.

In the years that followed, the Federal ReserveBank of JapanEuropean Central Bank and Bank of England all took measures to deal with a major economic downturn, which had spread globally.

One way they did this was through quantitative easing, where they bought large amounts of assets from commercial banks and institutions (including government bonds) while raising the supply of money in the economy.

The overall goal was to encourage lending, borrowing and consumer spending and to improve business sentiment, but there was another side effect they were hoping for — an increase in asset prices (including stocks). This side effect was realized, though not only through QE, but also because banks slashed interest rates to historic lows, which meant that bonds became less attractive for investors (due to lower returns). Because of this, investors sought riskier assets like stocks to generate higher returns. With more money being pumped into the stock market, the price of those securities increased. Central banks also hoped that by improving returns from stocks, they could also create a ‘wealth effect’, that would lead to higher spending too.

But that was the past and now all of this is changing.

The Fed in the US and the ECB in Europe are reversing their ‘easy money’ policies, because they think that the US and Eurozone economies are strong enough to stand on their own. It has taken 10 years, but economic markers are now being dubbed healthy enough to begin a long period of ‘unwinding’. The ECB confirmed in a statement on June 14th it would end QE bond purchases by December, while the Fed has already started unwinding its massive balance sheet after ending QE and is raising interest rates as both banks move to ‘normalise’ monetary policy.

What does this mean for investors?

Could things get bad for stock prices now that central banks are removing some support for the economy? Did QE really make that much of a difference to stock market valuations and is broader policy normalisation definitely going to hurt your portfolio? Opinions differ wildly on the matter, which makes things all the more confusing!

Writer Thomas H. Kee Jr. at investment publication MarketWatch said: “We believe that bonds, stocks and real estate will experience significant repricing in the years ahead, with the stock market at greatest risk. A 40% correction in the S&P 500 is possible.” Given the fact that many stocks in that index (particularly big names in the tech sector) look overpriced relative to their peers in other markets around the world, the earlier part of the argument seems like a fair assertion.

Then we have the counter-arguments. A report from Deutsche Bank in late 2017 said that QE may have impacted stock market movements by artificially boosting corporate profitability and by raising investors’ animal spirits, but the overall message was that strong earnings potential for US corporations indicated that corporate America is strong enough to withstand the withdrawal of QE and higher interest rates, and that fears that a withdrawal of stimulus could trigger an equity market meltdown appeared overblown.

Invstr CEO and former Deutsche Bank Director Kerim Derhalli is not so optimistic. He explained: “QE worked by boosting liquidity in the economy as the central banks bought bonds and gave the sellers of those bonds dollars or other cash in return. Many people agree that the liquidity that was generated contributed to the phenomenal rise in financial asset prices. As the Fed continues to unwind its $4.3trn balance sheet, the opposite will be true. The Fed will sell bonds on its balance sheet and drain US dollars out of the economy. This will reduce the liquidity available to purchase equities.”

He added: “Four other factors also bear watching: 1) Interest rates will rise making equities relatively less attractive than bonds. 2) Companies, especially emerging market companies who have added $40trn of debt since the debt crisis (!) will find it much harder to re-finance their bonds and loans in the capital markets. They will be competing for US dollar liquidity with the Federal Reserve. That will lead to more corporate insolvency and create pressure in the equity markets. 3) The US government has massively increased its budget deficit following President Trump’s tax cuts. That means that companies will be competing against both the Fed and the Treasury for liquidity. 4) The consequence of greater competition for dollar liquidity will mean a sharp rise in the value of the US dollar. This will have negative implications for US exporters and commodity producers creating further negative feedback for equity markets.”

Stock markets in the US in particular saw a large correction back in February this year, but relative stability has remained since then. Even with the knowledge that the era of QE and ultra low interest rates is beginning to come to an end, the S&P500 index is still up over 14% since June last year, with a slew of strong corporate earnings for bluechip companies through 2018 thus far too. It seems for most of the year, investors were betting that Jerome Powell and his fellow central bankers across the world would not make any significant missteps and that stock prices could remain high in the face of gradual policy normalisation.

Overall though, as billionaire investor Howard Marks put it to The Irish Times late last year: “We are in uncharted territory with all these central bank policies. We can’t say what will happen.” He added, “Anyone who says ‘I am completely confident in my understanding of the situation’ is really not that smart.”

A smart move for investors would be to keep an eye on this narrative as it develops. Whether the outcome of the withdrawal of stimulus measures is a huge correction in the markets, or whether it’s relatively minor in comparison, the end of the ‘easy money’ era is definitely going to have some impact on global stock indices.

Advertisements

India’s economy set to overtake UK – knocking it from The Commonwealth’s top spot

This week Britain is playing host to the leaders of The Commonwealth nations. As the event takes place, the UK will still hold the crown as the largest economy out of the 53 countries included in the lineup, but by the time of the next meeting in Malaysia in 2020, it’s almost guaranteed that India’s economy will have surpassed Britain’s in size. It will be a change that symbolises the tectonic shifts in the world economy, as Asia’s booming nations continue to challenge the economic dominance of the West.

Currently India stands at number 6 on the International Monetary Fund (IMF) world GDP rankings, with a GDP of over $2.26 trillion behind Britain’s $2.61 trillion, but bullish forecasts from both the World Bank (WB) and IMF suggest India will cruise comfortably into 5th place behind Germany in the next 2 years. The WB forecasts 7.3% growth this year for India’s booming economy, up from 6.7% last year, while IMF pegs it at a slightly more upbeat 7.4%. This will make India the world’s fastest growing economy in 2018, surpassing China.

But it’s not only India’s current shorter-term (1-2 year) growth prospects that should be cause for excitement, not least for investors in Indian equity markets. The longer-term equation looks equally lucrative. The Indian economy has plenty of room for future growth. Putting aside any external tailwinds from problems elsewhere in the world which could affect global trade and investment, India has the recipe for success including:

– A rising middle class which is spending and investing more.

– A young population (more than 65% below the age of 35) with more and more people entering the workforce, growing the pool of labor available for companies.

– A massive rural population that currently has low access to digital services and infrastructure, but with a government that is pushing to create a digital revolution in India, ecommerce companies like Amazon and Flipkart will be able to grow quickly as people who once never had access to internet start buying goods online.

– A stable government that has launched a flagship health insurance scheme to cover over 100 million families, while also pledging to invest large sums in the agricultural sector (the most important sector of the Indian economy accounting for 18% of India’s GDP which employs 50% of the nations workforce).

The IMF said today that India needs to address weaker aspects of its labour market and reform issues in its financial sector. With these issues solved, more jobs will be created and banks will feel more comfortable lending, both adding yet another stimulus to an already rapidly expanding economy.

Britain will now be looking to secure an even closer partnership with India, (which was referred to the ‘crown jewel’ of its empire in the colonial period), especially given the need it has to establish new trading relationships post-Brexit. It is likely that trade will be a key factor of discussion as representatives from both nations, and all other members of the Commonwealth community representing over a quarter of the world’s population, meet in London this week.

Trump puts world markets on edge – but relief for stocks may be at hand

Stock markets around the world took a large blow last week. The biggest factor at play was President Trump’s instigation of new tariffs on China over concerns of intellectual property theft – the second action on trade in as many weeks after the administration enacted steel and aluminium tariffs for the Chinese and other nations.

However the other reason concerned geopolitics, and perhaps the future of the world as we know it today. The sitting National Security Adviser at the White House H.R. McMaster was axed, and Trump replaced him with a former ambassador and mouthpiece for the military-industrial complex John Bolton. This appointment has palpably raised the prospect of an armed conflict between the United States and one of its adversaries, most likely to be Iran. Indeed, John Bolton called for Israel or the US to bomb Iranian nuclear facilities as recently as 2015, in an op-ed piece for the New York Times. Bolton was also a firm supporter of the war in Iraq, which many consider to be an illegal war driven purely for the benefits of American corporate interests, including oil companies.

Trump has seen more moderate and reflective members of his administration leave in recent months. Hope Hicks, who was known as having a calming influence on the President, left her post as White House Communications Director, shortly followed by Gary Cohn – Chief Economic Adviser. A former Goldman Sachs employee, Cohn had opposed Trump’s metal tariffs, and was one of the key players behind getting the popular tax reform bill passed last year. Soon after Rex Tillerson got the chop as Secretary of State, another moderate who favoured keeping the Iran nuclear deal and seeking a diplomatic resolution to tensions on the Korean peninsula. Trump replaced him with Mike Pompeo, the former CIA Director who holds a noted aggression towards Iran.

Jeremy Bash, a former Chief of Staff at both the CIA and Defense Department said on MSNBC that Trump was “assembling a war cabinet”. Given the direction of his team, this seems hard to argue with. With less mediating influences at his side, Trump will be less likely to hear opposing arguments from more dovish staff. Instead his views on Iran may be blindly accepted in an echo chamber where voices of dissent are minimal. Ironically, Trump ran on a platform based partly on withdrawing the US from expensive overseas wars, but he has constantly reaffirmed his commitment to increase military spending since he took office.

A war in Korea has been made less likely thanks to Kim Jong Un approaching South Korean leader Moon Jae In, but a question mark still hangs over the Middle East, not only because of the possibility Trump will scrap the Iranian nuclear deal, but also the prospect of a conflict erupting over Syria, where Russian forces are still propping up the Assad regime. Just last month, The Guardian reported that scores of Russian mercenaries had been killed by US airstrikes in the country as the US attacked pro-regime forces. If events like this continue to occur, the prospect of a confrontation between the US and Russia rises. Russia already resents the fact that NATO military buildup on its borders in Eastern Europe, and it goes without saying what a war between the two could mean for the global economy.

None of this is good news for the world as a whole, except those in the military-industrial complex who hold stock in military companies!

Today though things look brighter. US stock futures are up, on reports the US and China are trying to resolve the trade dispute behind the scenes. European markets are also driving higher led by the DAX (Germany 30). We have our fingers crossed that the worlds foremost superpowers can be pragmatic, adult and reasonable – though with Trump at the helm of one of them, this is not guaranteed.

The US Senate has voted to roll back Dodd-Frank rules for banks – what does this mean?

Last week the US Senate passed a bank deregulation bill that would begin the process of rolling back parts of the Dodd-Frank Wall Street reforms, passed during Barack Obama’s tenure. The original bill in 2010 placed restrictions on banks in order to try and prevent another meltdown like the world had seen during the financial crisis.

The new bill passed with 67 votes to 31, but was met with stern opposition from house Democrats, who argued that Republicans were undermining financial stability by voting in favor of reducing rules for lenders.

The new legislation would raise the threshold at which banks become subject to tighter oversight. Under the original Dodd-Frank act, a bank with assets greater than $50 billion is subject to stricter regulation, including stress tests. Now though, the proposed legislation would raise that threshold to $250 billion, a change that affects 25 of the 38 largest banks in the country.

The change would mean mid-level banks such as BB&T would not have to submit to the Federal Reserve’s stress tests (which were designed to make sure a bank could withstand a major financial crisis). Specifically, banks with less than $100 billion in assets would be immediately exempt from the current SIFI rules. SIFI stands for a ‘systematically important financial institution’, one whose failure may trigger a financial crisis. This basically points to a large scale relaxing of the rules and limits on the behaviour of small and mid-level banks.

Crucially, the new legislation gives banks with assets under $10 billion and limited trading assets a pass on the Volcker rule. This rule was put in place to stop banks from using their own accounts for short-term proprietary trading of securities, derivatives, and commodity futures, as well as other instruments. Derivatives in particular are known as riskier investments. 

The concern is that a rolling back of regulations (a common talking point for Trump in his speeches about the American economy) may lead to another financial crisis. The reasons for the crash in 2007/8 were many, but one key driver was deregulation in the financial sector before the crisis, which allowed banks to take on more and more risk, as well as becoming extremely highly leveraged.

It was a lack of oversight of the financial sector that encouraged banks to shift toxic financial products onto consumers, as well as between eachother.

The argument in favour of the changes to Dodd-Frank is that cutting red-tape could spur banks, especially local ones in smaller communities, to lend more, encouraging businesses and individuals to take on projects and generally put their money to work.

Some think the new changes to the bill are overstated. In a note to clients, Jaret Seiberg, an analyst at Cowen & Co said: “We believe this bill is broadly positive for regional banks and trust banks while offering little help to the mega banks.”

Whether or not the bill will really affect the bottom line of the ‘mega’ banks is yet to be seen, but it’s pretty clear investors think it will. Some big bank ETF’s saw record inflows this week. Bloomberg reported that 2 funds run by State Street Corp saw their biggest one-day inflows ever, with the SPDR S&P Regional Banking ETF taking in $606 million, and the SPDR S&P Bank ETF taking in $323 million, thanks to excitement about what deregulation could mean for bank stocks.

However we shouldn’t forget that these ETF’s have been on the up and up for the last year anyway because the Federal Reserve made clear it was raising interest rates, and that’s good news for bank profits. With 3 or 4 rate hikes forecasted for 2018, it’s unlikely investors will be disappointed.

Here’s the worry though – what happens if banks start taking on more risks again? What happens if the aspects of their business that involve trading riskier financial instruments get overlooked by regulators? The world economy is still only just recovering from a crash that was caused by the banks 10 years ago. It’s taken years of low interest rates, quantitiative easing and austerity measures to try and get markets back on an even keel. We are only just seeing central banks begin to talk about rolling back QE and start to push interest rates higher to ‘normal’ levels, yet now the Senate has decided to lower the safeguards 10 years after a crisis in which American households lost roughly $16 trillion in net worth.

Many will argue they have done so in error, but memories are short, and last year’s stock market rally has fuelled an irrational exuberance in the markets which has fuelled more risk taking. These changes to Dodd-Frank could undermine the system again before it’s even recovered, putting investors portfolios at risk.

The prospect of bank deregulation has helped financial stocks to rally over the last year, including JPMorgan Chase, Goldman Sachs, BB&T and Bank of America

The world economy is stronger but tensions are rising – a look at the OECD’s latest report

The OECD says the global economy will see its strongest growth in seven years in 2018 thanks to a rebound in trade and investment, though it also warned today that a trade war could threaten the recovery.

In its March 2018 interim economic outlook which used the subtitle ‘Getting stronger, but tensions are rising’, the organisation updated its outlook for G20 economies and raised its global growth forecast for 2018 and 2019 to 3.9 percent – the highest since 2011, from previous forecasts of 3.6 percent for both years.

The raised forecast is partly due to expectations that U.S. tax cuts will boost the American economy.

Here were the key positive takeaways from the report:

– Growth is improving or steady in most G20 economies

– Trade and private investment are bouncing back

– New fiscal stimulus in the United States and Germany will further boost short-term growth

– Inflation (a concern for Central Banks) is set to rise slowly

– Consumer confidence, particularly in BRIICS nations (Brazil, Russia, India, Indonesia, China and South Africa) has risen sharply

The key negatives and risks were as follows:

– Income gains, particularly for median and low income households have barely improved over the last decade

– Public and private debt in G20 nations is very high, with China leading the way at over 200 percent of GDP

– The pace of structural reform is slow, in emerging market countries especially

– An escalation of trade tensions would be damaging for growth and jobs

Regardless, the overall picture is healthier. Acting OECD Chief Economist Alvaro Pereira said: “We think that the stronger economy is here to stay for the next couple years,” He added, “We are getting back to more normal circumstances than what we’ve seen in the last 10 years.”

This is good news for investors the world over, as a more robust global economy will create a better environment in which companies can grow and expand more easily, boosting corporate results and shareholder returns.

Foreign investors move out of Indian stocks for now but future is brighter than ever for India’s economy

Indian stocks fell out of favor with overseas investors last month, with markets cooling slightly after a stellar 2017 performance. New data showed foreign institutional investors pulled out $1.5 billion from Indian shares in February, following the market correction in the U.S. which hurt global indices, on top of fears concerning the Punjab National Bank, which is at the centre of a $1.8 billion fraud case.

Gautam Chhaochharia, head of research at UBS Securities India said: “Our global strategists like Korea, Indonesia and Brazil the most.” He added: “A year ago, India was the market with least hassles in its path, but now, other emerging markets look better off in comparison.” Indeed, Brazilian and even Russian indices rode out the last month far better than their Indian counterparts. This Monday the NIFTY50 made a small recovery heading back to the 10,600 mark.

However these figures don’t tell the full story. Regardless of the recent blip in the equity market, India’s economy is still powering ahead as one of the fastest growing in the world, with plenty of praise being handed to the nations leader Narendra Modi for his implemented economic reforms which are making India more business friendly.

Indeed, India has plenty of reasons for positivity on the economic front. The country has vast supplies of natural resources which are relatively unexplored, and also has a huge need for new infrastructure projects, not only physical, but also in terms of digitisation due to its massive rural population. This presents major opportunities to foreign investors seeking to take advantage of a rapidly developing emerging economy. As digitisation expands it will bring benefits not least to these more isolated communities but also to foreign companies, because more access to the internet will draw in more and more e-commerce customers, a trend which Walmart has already taken an interest in. In 2013, India had 30 to 40 million internet users, while today the number is estimated to be over 400 million. Once again, these shifts will undoubtedly be a major pull for overseas investors.

On top of this, India has a flourishing middle class. By 2020, India is projected to be the world’s third largest middle class consumer market behind China and North America. By 2030, India is likely to surpass both countries with consumer spending of nearly $13 trillion. The Indian population’s interest in investing in stocks has also grown exponentially – domestic mutual funds got a whopping $20 billion in 2017, around double from the year before, mostly due to average (non-institutional) investors, who were looking to take advantage of the awesome stock market rally during the year, instead of sticking with more traditional choices like gold or real estate to put their cash into.

All signs point to a thriving economy in the long term. Indeed, the latest set of economic data for Q4 2017 showed India’s economy expanded 7.2 percent year-on-year for the period. That is well above the upwardly revised 6.5 percent advanced in the previous period and above market expectations of 6.9 percent.

Overall, whether foreign institutional investors are confident on Indian equity markets or not right now, the future looks bright. All of the fundamentals are in place which make India one of the hottest places on earth to invest.

India has a problem with its banking sector and it’s beating down equities

India is suffering from contagion in its banking system, with a mounting pile of non-performing loans, poor accounting standards and growing evidence of major banking fraud, unearthed over the last few weeks by government agencies.

India’s ratio of bad loans (as a percentage of total loans) is among the worst in the G20, just behind Russia and ahead of Brazil, Turkey and Indonesia, according to the IMF, though back in 2009 it was among the best in the world in this regard.

Standard & Poors Global Ratings said the recently detected fraud at Punjab National Bank underscores and urgent need for reforms in public sector institutions, with further losses for these banks being expected. Banking stocks were among the biggest fallers on the NIFTY50 last week, on top of significant monthly losses.

It’s an issue that the Narendra Modi’s Union government is taking steps to address. In October last year, the government unveiled a massive bailout plan to inject Rs2.11 lakh crore (equivalent to around $32.43 billion) into banks over the next 2 years to improve their capital positions. Stress tests conducted by the IMF last year on India’s 15 largest banks showed Indian lenders fell behind their emerging market peers including Indonesia, China and Russia in this regard. However it wasn’t all bad news – the IMF described 64 percent of the assets of the top 15 banks as ‘resilient’.

There are reasons to suspect that many more bad loans have not yet been accounted for. The latest corporate results from India’s largest lender (State Bank of India) showed the bank posted surprise losses of higher-than-anticipated bad loans, though officials from the bank claimed the worst is over.

The problems in banking have crept into the stock market too, unnerving foreign investors. If India wants to realise its true potential as an economy then the authorities will need to take a firm stance on the matter.