Central banks have reacted to the UK vote to exit the European Union, the most recent trigger of brief panic in markets, and tepid global growth with a series of forcible and coordinated actions, including further rate cuts, liquidity injections into the banking system, extended asset purchase programs, and, in the US, postponement of any interest rate increases. Incredibly, about one-third of all developed country sovereign bonds now have negative yields.
Monetary policies have pushed huge amounts of money into the global financial markets making money-market assets extremely unattractive to hold, boosting bond and risk asset prices, and alleviating the burdens of debt service. Low rates have also weakened those sectors of the financial system that require higher yields: life insurance companies, private and public pension funds with large unfunded liabilities (including those, for example, of Illinois and Connecticut), and fixed-income dependent savers.
Currently, the Japanese government can issue 40-year bonds at the unheard-of-yield of 30 basis points. Additionally, the Bank of Japan now owns approximately 38% of Japan’s sovereign debt and 55% of Japanese ETFs, making the Bank of Japan indirectly a Top 10 holder of 90% of the Nikkei 225.
As another example, the Swiss government yield curve all the way out to 50 years is in negative territory. Yet, around the world, the transmission of plentiful liquidity and low and negative interest rates to stronger final demand for goods and services has proven elusive.
In the US, the outlook calls for moderate growth and low and modestly increasing inflation. Job gains in June were strong, and indicators point to increases in labor utilization in recent months.
On the US fiscal front, deficits and debt discussions are notable by their absence in this political campaign season. The federal budget position is deteriorating slightly, but both presidential candidates profess faster growth will solve that problem among many. Any major effort to control the deficit will fail abysmally.
There are serious risks from abroad that could affect the outlook, whether a banking crisis in Europe, military confrontation in either the South or East China Seas, or renewed capital outflows from China generating currency tensions from a faster than anticipated depreciation of the yuan. At home, the risk of intemperate comments during the election campaign is high.
For the stock market, the first quarter likely marked a trough in year-over-year S&P 500 earnings per share growth. Second quarter earnings are coming in above consensus and should be up slightly year-over-year (versus down 5% in the first quarter). Ex-energy, second quarter earnings should be up about 5%.
In this unconventional environment, investors find it hard to agree on a basis by which to value stocks. The S&P 500 Index is selling somewhat above 16 times the consensus earnings estimate for 2017. The dividend yield is 2.1% compared with a 25-year average of 2.0% and the ten-year Treasury yield at 1.5%.
Despite breaking out to new highs, the stock market is unloved, maybe untrusted, with investor sentiment and positioning cautious. In fact, there were more mutual fund and ETF redemptions in the first half of this year than in the Great Credit Crisis of 2008.
Investors and central banks have been well-conditioned to expect “bad news” surprises, not pleasant ones. But the metrics of a classic end-of-cycle, bear market are NOT present: problematic inflation, a hostile Fed, an inverted yield curve, credit crunches, recession prospects…and investor optimism and euphoria!
