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.

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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.

China vows to retaliate to U.S. tariffs on steel and aluminium as prospect of trade war looms

The Chinese government in Beijing has confirmed it will retaliate if the Trump administration goes ahead with a plan to place tariffs on steel and aluminum imports from China and other nations including Brazil.

In the latest progression in tensions between the 2 countries, Wang Hejun, a senior official at China’s Commerce Ministry said: “If the final decision from the U.S. hurts China’s interests, we will definitely take necessary measures to protect our rights.”

He was of course referring to proposals drawn up by U.S. Commerce Secretary Wilbur Ross, who last week recommended Trump should impose tariffs on foreign suppliers of metals due to ‘national security’ issues, as well as unfair trade practices including steel ‘dumping’. Dumping is the process of keeping steel prices artificially low, which has the effect of pricing other producers out of the market. Republicans in Washington argue that this practice negatively impacts the ability of U.S. steel companies to compete, thus hitting communities in America which have depended strongly on manufacturing jobs, and have been decimated by the closure of factories, particularly across the rustbelt.

Trump’s more protectionist rhetoric on trade and his skepticism of globalisation resonated strongly with voters in these communities in 2016, yet this is an age-old problem that was a hot topic even under Obama. Even notoriously anti-Trump news outlet CNN formerly sympathized with his perspective. In a report in 2016, CNN said that the American steel industry was “being hurt by an unprecedented surge in unfairly traded imports, with record amounts of foreign-produced steel flooding into the United States. Cheap, subsidized foreign imports are taking steel jobs away.”

Whether these tariffs are good for the American worker is yet to be seen, because this is only the second salvo to be fired in what could become a full blown trade war, but it’s fair to say the ramifications of this action from the Trump administration will be significant, given that China produces around half the world’s steel. Trump has until mid-April to decide on whether to go ahead with the proposals, which would mark the second major action on trade after he imposed tariffs on solar panels and washing machines from the Asian superpower in January.

The move won’t be a surprise given the rhetoric Trump used during the campaign and in his first year in office. He’s set his sights on renegotiating everything from how much NATO members spend on their military budgets to coming down hard on Canada’s lumber industry, whereby the Department of Commerce set total import tariffs at above 20 per cent for most Canadian softwood lumber producers last November.

China’s Ministry of Commerce soon went on the defensive, and said the conclusions from a US departmental national security review of the steel and aluminium industries were incorrect, because China has proven its products did not threaten U.S. national security. Wang Hejun said: “The spectrum of national security is very broad. Without a clear definition, it could easily be abused. If every country followed the U.S. on this, it would have serious ramifications on the international trade order.”

The American oil industry is booming and that may undermine OPEC

America may well become the world’s leading energy producer by next year, according to the International Energy Agency.

The latest IEA report said that in the 3 months to November last year, U.S. crude output was seen increasing by 846,000 barrels a day.

The data revealed how fast rising production in non-OPEC countries (led by the U.S.) is likely to grow by more than demand this year. The relentless rise of American crude supply could undermine OPEC efforts to re-balance the global oil market, and may see the U.S. overtaking Saudi Arabia and Russia (two of the world’s largest producers) in oil production by the end of 2019.

Head of the oil industry and markets division at the IEA Neil Atkinson said: “We are seeing United States production rising very, very dramatically before our very eyes and that’s likely to continue in 2018.”

One reason this trend looks set to continue may be due to the Trump administration’s willingness to open up more areas in the U.S. to oil production. The U.S. Department of the Interior announced that it may conduct 16 auctions to open new oil and gas wells along the Atlantic and Pacific continental shelves. It will also sell 31 new leases near Alaska and in the Gulf of Mexico.

U.S. energy exports now compete with Middle East oil for buyers in Asia, and daily trading volumes of U.S. oil futures contracts have doubled in the past 10 years, according to the CME Group. This indicates just how much America has grown as a major player in world energy markets.

Conversely, the latest OPEC report showed production for the members of the group was little changed in January as they continued to limit their output for a second year in order to balance an oversupplied market. However, key members like Iraq raised their output in the first month of 2018.

Crude prices have jumped nearly 50 per cent since mid 2017 reaching highs of over $70 a barrel but have since lost steam, now sitting at around $62 p/b.

Patrick Jones

Fed sounds hawkish on interest rates / Trump tax reforms in focus

September 27th

Yesterday Federal Reserve head Janet Yellen reaffirmed the central bank’s commitment to keep pushing interest rates higher, saying that it should not be too gradual in its approach – words that will be seen as refreshingly hawkish to many investors. Confirmation of another rate hike in December has pushed bank stock prices higher this morning once again, even across Europe.

Today a major focus for investors will be what President Trump announces about tax reform in a speech later today in the US. A plan to simplify the American tax code and cut tax rates for individuals (especially those in the middle class) and companies, was a key message in Trump’s campaign. It is expected that the tax rate for corporations will be reduced by 15%, from 35% to 20%.

Though Trump has repeatedly stated that rates for businesses would be reduced to 15%, Republican Speaker of the House Paul Ryan (pictured shaking Trump’s hand) indicated in a New York Times interview recently that this may not be a realistic option. Still, any cuts they can get through would potentially be a great leap forward for the US economy and benefit investors simultaneously.

By reducing overall taxation, US companies may become more competitive financially. With lower rates across the board, many firms who were tempted to move abroad to save capital (cheaper labour costs, lower taxes) may choose to stay in the US too, creating more jobs instead of laying off their US-based workforce. A more favourable environment for businesses and individuals is likely to spur economic growth (which will boost stock markets too). The question now is whether the team behind tax reform can convince congress of the merits of the plan and get it passed.