Economic & Market Review - April 2015

by Gavin Graham, Chief Strategy Officer April 12, 2015
Notice: This newsletter is intended as a general financial market outlook, and should not be relied on as investment advice.
Stock markets hit new all-time highs in nominal terms during the first quarter, with the venerable Dow Jones Industrials reaching 18,288 on March 2nd 2015, up an astonishing 2,400 points or 15.3% from its 52 week low, seen as recently as mid-October last year. The broader S&P500 was up 16.8% from its October lows to a new high of 2119 at end of February while the technology-dominated NASDAQ did best of all, rising 27.8% to 5046 over the last 12 months to marginally surpass its previous high of 5000 first reached fifteen years ago in early 2000.

Canadian stocks have not done as well, owing to the heavy weighting of energy stocks in the S&P/TSX Composite, as the price of oil fell by half between July and December 2014, from over U$100 per barrel to under U$50. The index is only up 4.5% over the last year, and the US dollar has strengthened against the Canadian dollar, as it has against all other major currencies, moving from U$0.943=$1 in July 2014 to U$0.797=$1 at the end of March, adding an additional 15% to US returns for Canadian investors.

In Europe, the UK FTSE100 and the German DAX hit new highs in early 2015, with the former up 16.3% to 7065 from its October lows and the latter up a remarkable 46.3% to 12219 as the European Central Bank (ECB) finally started its Quantitative Easing (QE) programme. Of course, the last time the FTSE was touching 7000 was also in early 2000, and in real (inflation adjusted terms) the recovery of the US and European markets to hit record nominal highs still leaves them down 30-40% in real terms after taking account of inflation over the last 15 years.

The lack of real progress by equity markets is even more starkly illustrated in Asia, where the second round of QE by the Japanese authorities in late 2014 saw the Nikkei 225 up 42.4% over the last year to 19,778 in March, more than double its level of three years ago, but still 50% below its previous all-time high of 38,900 attained on the last day of December 1989. In 25 years, in other words, the Japanese stock market has lost three quarters of its value after inflation. An even more impressive short term performance has been delivered by the Shanghai Composite Index, which effectively doubled from 1991 in May last year to 3864 at the beginning of April, an increase of 94%. Unlike the Japanese market, where the Japanese yen has declined 18% from July last year against the US dollar, the Chinese renminbi is effectively pegged against the greenback, delivering a 90% return for dollar denominated investors. India’s Sensex has also climbed rapidly following the election of the business friendly Modi government in April 2014, rising 35%.It is therefore accurate to note that, with the exception of commodity dependent economies like Canada, Australia and Russia, where a weak stock market has been exacerbated by declining currencies, owing to the sharp fall in commodity prices, stock markets around the world are booming as a result of the QE programmes being followed by the authorities in Europe, China and Japan.

So too are government bond markets, where the fall in headline inflation due to lower energy and material prices has seen bond yields, far from rising due to expected increases in short term interest rates, instead decline sharply. The benchmark 10 year US Treasury bond yield has fallen 115 basis points (1.15%) from 2.8% in April 2014 to 1.65% now, the 10 year UK gilt from 2.8% in April to as low as 1.33% in January (now 1.63%), while the 10 German Bund, driven by flight capital worries over a Greek exit from the Euro, is down from 1.65% last April to 0.13% today, a level never seen before in 200 years. Shorter term bunds have negative interest rates out to 5 years (in other words the investor has to pay the state to own its bonds), as is the case for other Euro-zone countries such as Belgium and the Netherlands as well as Switzerland and Denmark. Even possible candidates for exit from the Euro-zone such as 10 bonds issued by Italy and Spain only yield 1.25%. Japanese 10 year JGBs, already by far the lowest yielding amongst major markets, saw their yield halve from 0.65% to 0.32%.

The reason for the strong returns from both non-commodity stock markets and bond markets is, of course, the continuation of record low interest rates in the developed world. Compared to the so-called “taper tantrum” in May 2013, when concerns over a possible rise in short term US interest rates due to the expected end of QE in the US, which saw markets sell off 10-20% in a few weeks, the finish of the US Federal Reserve’s U$80 billion a month purchases of bonds and mortgages at the end of 2014 only caused a minor hiccup. The strong GDP growth in the US and the fall in oil prices saw capital flooding into the USA, which is perceived as a safe haven, hence the strength in the currency.

However, as we at INTEGRIS have been pointing out for the last few months, real returns from developed government bonds over the next decade are guaranteed to be unattractive and certainly well below the levels required to provide the pensions beneficiaries have been led to expect. Investors, if one can so describe them, who are buying short term European government debt at negative interest rates will lose money in nominal terms let alone after taking inflation into account. Unless oil prices fall further and remain at low levels for the next few years, energy prices will begin to rise in the second half of this year, if only due to the comparison with their levels in late 2014.

Similarly, after such strong upward moves by stock markets in the last six to twelve months, returns are likely to be much lower, if only because earnings have not grown anything like as fast as stock prices have risen. In fact, earnings for the S&P500, 40% of which are derived from outside the US, are actually declining due to the negative effect of the strong US dollar. This leaves markets at the most expensive valuation since the end of the bull markets in 2000 and 2007, and returns from markets when they are this expensive have averaged between -5%-+2% p.a. over the following decade, according to analysis of the last century’s records.

Investors and pension fund trustees should ensure that their asset allocation is rebalanced to reflect their original intentions, and closely analyse their managers’ views on the outlook for the next twelve to eighteen months, which of course includes a US presidential election. Despite its minimal yield, cash at least will preserve capital in nominal terms over the near future and allows flexibility to take advantage of buying opportunities should the present bullish investor sentiment change for the negative.

Information from Bloomberg and Globe and Mail as at April 5th.