Market Recap

Posted on October 2, 2015 by Gemmer Asset

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It was a pretty interesting week with generally downbeat economic data offset by hopes that the weak data would lead to either policy stimulus or at least no tightening.  For the week the S&P added +1.0% but small-cap U.S. stocks lost -0.8%.  Overseas markets did well with the developed EAFE adding +1.8% while emerging equities spiked +4.4% higher.  Markets are also being supported by the sentiment backdrop.  When everyone is bearish equities typically do the exact opposite.  As you can see below, the ratio of bulls to bears is at the lowest point since 2011.




The weak economic data pushed bond yields down materially.   The yield on the 10-year closed at 1.99%.  This meant intermediate-term government bonds gained +1.4% while long-term bonds jumped +2.5%.  The only pocket of weakness in the fixed income area was high-yield.  Worries about deteriorating credit quality and rising defaults pushed the high-yield index down -1.9%.  Even higher quality corporate bonds have struggled of late.  As you can see below, spreads on BBB rated bonds have increased from just 1.4% in July to 2.4% today (this means they have gone down in value).




Furthermore, junk bond yields jumped to over 8% this week. This is the first time in 3 years yields have moved this high. Until recently the pain in the high-yield market was largely confined to the energy and commodity sectors. But this week it spread into other areas such as telecom and media. Unnerving corporate bond investors were two major events:


– A Japanese shipping group, Daiichi Chuo, filed for bankruptcy.


– The commodity giant Glencore is coming under major pressure. With $30 billion of debt outstanding, some analysts speculate that the equity in the firm has zero value.


Problems in the junk market are coming at the same time global economic data is softening.


The Global Economy is Stuck in the Mud


Global economic reports this week really highlight just how soft growth has become:


1) First off, Friday’s payrolls report was lousy. Jobs increased by +142K in September, well short of the +200K expected. It is also disappointing that the number for August was revised lower. Granted, the unemployment rate was unchanged, but only because the participation rate fell to 62.4%, a new cyclical low.


2) Next up are the regional manufacturing reports. The main one this week was the Chicago purchasing manager’s index for September. This came in at only 48.7, well below expectations of 53 (see chart below). This is the fifth time this year that the index fell below 50, the border between expansion and contraction.




3) This set the stage for the national ISM manufacturing index.  This was weak as well, falling to 50.2%, barely above the growth line (chart below).



4) All of this means inflation expectations are falling hard.  The chart below shows inflation expectations priced into the market today.  Specifically, this shows five year inflation expectations five years out.  As you can see this has fallen to the lowest level since 2010.




5) Overseas numbers were not much better. Japan’s industrial output unexpectedly fell, raising concerns that the economy may have fallen back into its second recession since Prime Minister Shinzo Abe took government.


This has prompted the Abe administration to roll out new support measures. Specifically, on September 24th Abe launched three new arrows for reform (his first three arrows, monetary easing, fiscal stimulus, and structural reforms, were shot shortly after taking office). He is formally targeting a 20% increase in gross domestic product to 600 trillion through renewed economic and social reforms.


This move also raised the probability that the Bank of Japan will increase their bond buying, or so called quantitative easing (QE), in the fourth quarter.


6) Finally, the main news in Europe concerned inflation. Consumer prices in the eurozone fell annually in September for the first time since the European Central Bank (ECB) launched its program of government bond purchases in March. As you can see below, eurozone inflation fell -0.1% in September, with German prices falling -0.2% while Spanish prices declined -1.2% year-over-year.




This report puts increasing pressure on the ECB to counter the renewed threat of deflation with even more stimulus. Speculation is that the ECB will extend their ongoing QE program into 2018 – adding significantly to the total amount of bonds likely to be purchased. Some analysts speculate that any extension could double the size of the current QE program.


The Emerging Market Blues


Then there are the emerging markets. Both EM bonds and stocks have been a house of pain this year, and the International Monetary Fund (IMF) added to the downbeat news flow with a new report this week. Basically they warned that the large increase in corporate debt in the emerging world puts many countries at risk. For example, the corporate debt of non-financial firms across major emerging market economies increased from about $4 trillion in 2004 to well over $18 trillion in 2014. This means that debt-to-GDP has gone from 49% to 74% (chart below). According to the IMF this raises concerns because many emerging market financial crises have been preceded by rapid leverage growth.




To quote the IMF:


“A key risk for the emerging market corporate sector is a reversal of postcrisis accommodative global financial conditions. Firms that are most leveraged stand to endure the sharpest rise in their debt service costs once monetary policy rates in some key advanced economies begin to rise. Furthermore, interest rate risk can be aggravated by rollover and currency risks. Although bond finance tends to have longer maturities than bank finance, it exposes firms more to volatile financial market conditions. In addition, local currency depreciations associated with rising policy rates in the advanced economies would make it increasingly difficult for emerging market firms to service their foreign currency-denominated debts if they are not hedged adequately.”


And this last point is important. We have seen a huge increase in foreign currency denominated bonds in the emerging world (chart below). Further dollar strength would put significant pressure on many corporations.




And this risk is being born out in the financial markets as capital flees the sector for the first time since the 1980s. As the FT notes:


“The Institute of International Finance said it expected foreign investor flows to EMs to fall to just $548bn this year, lower than levels recorded in 2008 and 2009 at the height of the global financial crisis. Combined with accelerating outflows from resident investors, it said net capital outflows would amount to $540bn this year, the first time this had been seen since 1988 (chart below).”




Markets Drive Policy…and Policy Makers Can’t Ignore Markets


But much of the downbeat data is well known, especially the problems in the emerging world. Given that markets are priced at the margin, what new implication comes from the above points? Or more immediately, why’d the markets rally on Friday?


It all comes back to expectations for policy. The odds of a fed hike fell significantly this week. Traders see no chance of a rate hike in October. The odds are only 30% for December, and January and March come in at 37% and 51% respectively. And this is why EM rallied as hard as it did on Friday (+2.6%). If EM risks are tied directly to a Fed hike, falling odds are interpreted as a positive development for EM assets. The same holds true for global equities.


We are still in a world where policy makers around the world can’t ignore the markets, even though they deeply wish they could. The Fed in particular can’t ignore the problems in the emerging world at the same time growth in the U.S. is faltering.


Their hands are tied.


Charles Email Sig







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