From Brexit and Trump to Italy, Brazil and the Philippines, 2016 has been a year of political upheaval and theatrics. And it isn’t over yet. South Korean President Park Geun-hye is embroiled in an influence peddling scandal that has outraged the country and likely numbered her days in office. She has offered to step down from office in April 2017—10 months before her term is slated to end—but lawmakers in the National Assembly instead introduced an impeachment bill, which gets a vote Friday December 9. While Park’s political fall looks inevitable, Korea’s political issues needn’t derail its other positive drivers. For global investors, whether or not you own any Emerging Markets stocks, this is another lesson in the importance of thinking long-term and not getting hung up on short-term events.
The movement against Park appears more about her actions (which you can read all about here), not a broader distaste with the government or the state of society. After decades of chaebol (Korea’s huge, family-run mega conglomerates/corporate fiefdoms) dominating political decisions and the economy, corruption has emerged as the societal cause du jour (see this summer’s draconian corruption bill), and Park appears a victim of the times. The scandal also coincides with some economic softness, as a slowdown in global trade hit export-oriented businesses hard. In response, the country’s largest sectors—which account for a fifth of GDP and employ nearly 15% of the workforce—have undergone significant corporate restructuring. More recently, scandals at several chaebol only further weighed on sentiment.
South Korea has also faced some geopolitical uncertainty in recent months. Besides long-running issues with North Korea, which has made progress in its nuclear program, new tensions with China have arisen as South Korea recently deployed an advanced US missile system. In addition, Donald Trump’s victory made many call into question the future of Asia’s trade relationship with the US given his campaign rhetoric and dismissal of the Trans-Pacific Partnership. There is also a potential domestic political headwind, as the legislature’s opposition party favors tax hikes, with eight different proposals put in the supplementary budget bills. With one of the world’s stronger fiscal positions (40% debt to GDP), such a move makes little economic sense, but the negative fallout is likely short term.
There’s more where that came from. Photo by yodiyim/Getty Images.
At long last, the Organization of the Petroleum Exporting Countries (OPEC) reached an agreement to cut production on Wednesday. While details are scarce, comments from oil ministers indicate the group will cut oil production to 32.5 million barrels per day (Mbpd), from recent levels of 33.5 Mbpd. Despite the hype, however, the change is basically window-dressing. It probably won’t much alter global supply or improve the outlook for Energy firms. Their earnings are tied to oil prices, which likely remain lackluster for the foreseeable future (albeit with short-term volatility).
This is OPEC’s first official action of this sort since oil began crashing in 2014. OPEC surprised markets that November by declining to cut production, as had been widely expected at the time. Oil supplies were growing briskly, primarily due to new output from US shale production, which got a boost from developments like horizontal drilling and hydraulic fracturing. The resulting oversupply led to the last two years of oil weakness. With Wednesday’s agreement to cut production, OPEC is arguably moving back to its traditional role of attempting to target a price range for oil.
In a year where populism has swept the ballot box, is Italy next? On December 4, the country will hold a referendum on whether to reform the size, powers and appointment process for Parliament’s upper house, the Senate. If the referendum is approved, the Senate’s powers would be greatly curtailed and size reduced. It would shrink from 315 members to 100, the government would no longer have to win a Senate confidence vote, fewer measures would require Senate approval and senators would be appointed by Italy’s Regional Councils instead of directly elected. If passed, it would foster government stability and make it easier to pass badly needed reforms. But if it fails, many fear it will destabilize Italy’s pro-euro government, potentially propelling anti-euro populists to power and raising the risk of a domino effect across the eurozone. In our view, however, fears of broader market impact are likely overstated.
Prime Minister Matteo Renzi proposed the referendum to mitigate the Senate’s ability to block legislation and increase the Italian government’s stability, through elimination of one confidence vote. However, he also indicated his government will step down if the referendum is defeated. Opposition parties, such as the Five Star Movement (M5S), are against the referendum, as they believe it gives too much control to the Prime Minister. Many believe a Renzi resignation could give M5S an opening to enter the national government.
Italy doesn’t allow the publication of polls 15 days prior to an election or referendum, but the last polls indicated the “No” vote was ahead by about three points. PredictIt, a betting website similar to the late, great InTrade, puts the odds of the “No” vote prevailing at ~80%. But as US elections and the Brexit vote showed, polling and prediction have been unreliable lately. The considerable number of undecided voters (~20%) also suggests any poll isn’t conclusive.
A few months ago, 10-year Treasury yields hit an all-time low of 1.36%, as investors piled into Treasury bonds in the wake of the Brexit vote.[i] Since then, Donald Trump’s win and expectations for higher inflation have sent yields up 70 basis points (0.70%).[ii] As rates have risen, so have fears about the end of the alleged 35-year bond bull market—and the possibility of a bond bear market, should rates climb higher. Since bond prices and interest rates move inversely, many seemingly fret higher rates mean bonds are doomed to poor long-term returns—arguing bondholders should ditch them post-haste. In our view, this overlooks important nuances suggesting the case for investors who need fixed income exposure hasn’t changed.
First, let’s look at the last 35-ish years of yields—that long-term bond bull. Fast-rising inflation and aggressive Fed rate hikes pushed 10-year yields to 15.84% in 1981. But after the Volcker Fed put inflation in check, rates began a secular move downward to recent lows. However, this wasn’t a straight line down.
As Exhibit 1 shows, bond yields went through several cycles where yields increased. Since 10-year US Treasury yields peaked in September 1981, rolling 12-month yields rose 35% of the time.[iii] Even if yields do experience a long-term climb, odds are investors will see plenty of periods where yields fall. Having an actively managed fixed income strategy can help take advantage of these opportunities.
With oil up from its most recent low, many see a prime opportunity in Energy stocks. However, despite oil’s nascent rebound, the bigger picture hasn’t changed. The primary headwind facing Energy is an oil oversupply, which puts downward pressure on prices. Even if prices don’t plunge anew, this force still impacts the sector’s future profits. For investors, the question isn’t, “how much have prices risen recently?” Rather, it’s, “are there any meaningful supply constraints that will alleviate pressured profits?” All evidence today suggests there aren’t, making it premature to load up on Energy stocks.
Demand growth likely remains steady, as it has since 2012, but supply probably won’t abate any time soon. Domestic producers are quick to bring supply back online at the first signs of price strength. As seen in Exhibit 1, US producers have responded to stronger oil prices by putting rigs back to work, with a narrow lag time of only three months. In many shale regions, new wells are profitable with oil at $40 a barrel, according to estimates by ConocoPhillips. Indeed, the abundance of US supplies—accessible at ever-lower costs—led ExxonMobil CEO Rex Tillerson to refer to domestic shale as a source of “enormous spare capacity,” which has visibly changed the industry. That quick producer response and abundant supply dampens the likelihood oil prices significantly rise over the next 12-18 months.
Exhibit 1: Rig Count Response to Oil Prices
|By Fisher Investments Editorial Staff, 10/11/2016|
MarketMinder’s editorial staff sits down with Fisher Investments Capital Markets Analyst Scott Botterman.
|By Fisher Investments Editorial Staff, 10/11/2016|
MarketMinder’s editorial staff sits down with Fisher Investments Capital Markets Analyst Austin Fraser.
Political uncertainty is stoking fear across much of the developed world. In the US, pundits pontificate about the potential negative market impact from either a Donald Trump or Hillary Clinton presidency. Similarly, recent and upcoming votes in the eurozone’s four biggest economies—Spain, Italy, France and Germany—have contributed to an environment of fear and loathing across the Continent, causing many to miss the region’s overall fine economic results. Time and again, forecasted political “disasters” have had a limited impact on the fundamental environment in Europe. The Brexit vote increasingly appears to have had little economic impact, with the most recent data pointing to the 14th consecutive quarter of expansion in Q3. Even long-beleaguered European Financials stocks are doing better, as issues like negative interest rates and regulatory changes have failed to live up to fears. While the upcoming votes might bring minor political shifts, all appear unlikely to result in big, sweeping change. Instead, they likely push governments deeper into gridlock—an underappreciated positive—which reduces uncertainty and legislative risk.
Spain is likely headed to its third general election in a year after its fragmented parliament failed to form a government following June’s election. Prime Minister Mariano Rajoy of the center-right Popular Party (PP) was unable to win a confidence vote to form a minority government with upstart, centrist Ciudadanos. If neither Rajoy nor the opposition Socialist Party is able to form a government by Halloween, Spanish voters will return to the voting booth—potentially on Christmas Day.
|By Christo Barker, 03/28/2016|
Financials stocks took it on the chin during 2016’s first six weeks, as investors freaked out over banks’ Energy exposure, eurozone banks’ capital ratios and bad loans, and negative interest rates. While these issues have impacted sentiment, in our view, they are overstated or misperceived. Energy loans lack the balance sheet exposure to ripple systemically. Negative interest rates are poor monetary policy but apply only to a tiny portion of global bank reserves. Bank lending is improving in most of the world, including the US and Europe, and bank balance sheets are the healthiest they’ve been in a generation. We believe the US and European financial systems are quite healthy and the risk of another near-term financial crisis is extremely low.
1. Potential Energy Loan Defaults Lack Scale
In the US, Energy loans account for just 3% of total loans—tiny. Overall, US banks were already conservatively positioned with 1.5% of loans set aside to cover all potential bad debts. Even with this conservative buffer, banks modestly stepped up these provisions as a precautionary measure, further limiting potential energy fallout. Just 6% of outstanding Energy debt globally is on bank balance sheets, while 86% is in the bond market. (Exhibits 1 and 2)
Some compare Energy loans today to subprime mortgages and 2008’s financial panic, but these fears lack credibility. Banks’ real estate exposure in 2007 amounted to 110 times their Energy exposure today. Plus, that 3% balance sheet exposure to Energy includes loans to huge integrated firms and state oil companies—neither have legitimate default risk. Even if half of the outstanding Energy loans were to default—extremely far-fetched—the conservative position of bank balance sheets is well-positioned to limit any major fallout from such an event.
Over the past year bond market liquidity—the ability to quickly redeem an asset for cash without moving the price much—has gone from an obscure, seldom-mentioned topic to one of the financial press’s favorite fears. Worries centered on high-yield exchange-traded funds (ETFs), with pundits and prominent investors frequently warning they operate on the illusion of liquidity. We’ve addressed this issue several times on MarketMinder (here, here and here). I won’t rehash those points in full, but for a quick refresher, regulatory changes made bond dealers less willing to hold large inventories and act as intermediaries. This, pundits theorize, makes bonds less liquid. Compounding the issue is the increased use of ETFs that promise equity-like liquidity but are backed by much less liquid bonds. This “mismatch” is the alleged liquidity illusion, and many claim a high-yield selloff and the accompanying high volumes will reveal a rough reality: that investors can’t redeem quickly without accepting dramatically lower prices. Yet despite a deep correction and record volumes in high-yield ETFs in 2015, we’ve seen no signs of liquidity issues. High-yield ETFs’ liquidity isn’t an illusion. These fears miss ETFs’ ability to create very real liquidity of their own.
To better understand why these liquidity concerns are false, let’s first consider bond ETFs’ size relative to their underlying benchmarks. High-yield ETFs are a fairly new investment tool—the first launched in 2007. Since then, they have gained popularity and, as of November, had over $42 billion in assets.[i] Yet despite the rise in high-yield ETF assets, they represent only a small portion of the US dollar-denominated high-yield market. In other words these ETFs are too small to dictate what happens to the overall index—it’s the other way around.
Exhibit 1: Total Value of High-Yield ETF Assets as a Percentage of High-Yield Index Market Value
Pundits have taken to calling the Bank of Japan’s latest policy trick—negative interest rates on central bank deposits—a Jedi Mind Trick. But BoJ Governor Haruhiko Kuroda seems to have a different pop cultural inspiration when he stated last year: “I trust that many of you are familiar with the story of Peter Pan, in which it says, ‘the moment you doubt whether you can fly, you cease forever to be able to do it.’ Yes, what we need is a positive attitude and conviction. Indeed, each time central banks have been confronted with a wide range of problems, they have overcome the problems by conceiving new solutions.”
Trouble is, in Peter Pan, flying also required magic fairy dust, and neither quantitative easing (QE) nor negative interest rates qualify. They’re more like forcing banks to walk the plank.
The BoJ’s massive QE program, now coupled with negative interest rates on new excess reserves, has pushed Japanese yields negative all the way out to 10-year maturities. Negative yields are intended to make Japanese Government Bonds (JGBs) unattractive—effectively a “tax” on savers (lenders)—promoting consumption or investment in higher yielding or riskier assets. Yet in the short term, it has done the opposite.
Stop me if you’ve heard this one: China is slowing, and that spells trouble for the world economy. I’m going to go ahead and presume the vast, vast, majority of readers are familiar: A slowdown in Chinese economic activity has been feared for years and was an enduring concern in 2015. Investor anxiety surrounding the world’s second-largest economy was widely blamed for a mid-year global equity market correction. But in an interesting twist, while China slowed, the eurozone—which many consider an economic quagmire to this day—sped. And, given the eurozone’s larger aggregate GDP, the acceleration has more than made up for a slower China in the last two years.
Fears of a seemingly unending European malaise the last several years suddenly faded this summer as China’s fast growth slowed. Facts were inconvenient— it didn’t seem to matter much that:
1. The slowing was largely government-orchestrated and has been occurring for years.
Editors’ Note: Our discussion of politics is focused purely on potential market impact and is designed to be nonpartisan. Stocks don’t favor any party, and partisan ideology invites bias—dangerous in investing.
Are drug prices running rampant? After The New York Times reported on Sunday that a small private Pharmaceuticals firm, Turing Pharmaceuticals, jacked up the price of a 62-year-old drug by 5,000-ish percent, that question has sparked a media firestorm.[i] Monday, partly in reaction to the news, Democratic Presidential front-runner Hillary Clinton fueled further debate by vowing to “deal with skyrocketing out-of-pocket health costs and particularly, runaway prescription drug prices.” All week, media articles aplenty have focused on the issue and wondered whether Federal price controls are necessary to put a lid on the rise. But whatever your opinion of the sociological merits of this plan or drug prices, price controls in general have a long history of causing more harmful unintended consequences—including dinging stock prices—than any positive they may bring. That being said, pharmaceutical price controls seem unlikely to come to fruition any time soon.
For those interested in the details of Mrs. Clinton’s plan, here are the major proposals:
Market liquidity is usually a pretty banal subject, garnering little attention. But in the last year, it has gone from being a dry afterthought to being the subject of frequent articles claiming it’s a major concern, particularly in the bond markets. So much so, that Bloomberg’s Matt Levine had a running section of his daily link wrap titled, “People Are Worried About Bond Market Liquidity” for months and rarely ran low on articles to share. It is now bigger news when there aren’t “People Worried About Bond Market Liquidity!” So what is market liquidity, and are the recent fears justified—or overblown?
Market liquidity refers to how easily an asset can be bought or sold without dramatically impacting the price or incurring large costs. It’s a defining feature separating asset classes, a key consideration for investors. Some financial assets, like listed stocks, are easy to buy or sell with little price impact and small commissions—they’re “liquid.” Conversely, commercial real estate takes time to sell and likely includes high commissions and significant negotiations—it is “illiquid.” For most investors, particularly those with potential cash flow needs, liquidity is an important facet of any investment strategy.
Bonds are among the more liquid investments available for investors, though liquidity varies among different types. Treasurys, among the deepest markets in the world, are highly liquid. Corporates and municipals are less so, and some fancier debt is actually quite illiquid.
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Korean President Park Geun-hye’s fall from power shouldn’t override the country’s other positive drivers.
OPEC’s agreement to cut production doesn’t mean oil is set for a sustained rebound.
In a year of political upheaval, Italy’s forthcoming referendum hardly rates.
What fixed income investors should weigh when considering rising interest rates.
Searching for opportunities in the Energy sector still seems premature.
Market Wrap-Up, Thursday, December 8, 2016
Below is a market summary as of market close Thursday, December 8, 2016:
- Global Equities: MSCI World (+0.2%)
- US Equities: S&P 500 (+0.2%)
- UK Equities: MSCI UK (-0.0%)
- Best Country: Japan (+1.0%)
- Worst Country: Austria (-1.4%)
- Best Sector: Financials (+0.8%)
- Worst Sector: Consumer Staples (-0.3%)
Bond Yields: 10-year US Treasury yields rose 0.06 percentage point to 2.40%.
Editors' Note: Tracking Stock and Bond Indexes
Source: Factset. Unless otherwise specified, all country returns are based on the MSCI index in US dollars for the country or region and include net dividends. S&P 500 returns are presented including gross dividends. Sector returns are the MSCI World constituent sectors in USD including net dividends.