Stocks officially entered a bear market last week, at least as measured by the MSCI World index. But then that isn’t exactly news in a lot of places on the globe with various markets around the world having eclipsed the down 20% threshold long ago. The S&P 500 is so far avoiding the ursine fate, down a mere 15% at the low last week although if you asked the average investor or hedge fund manager I’ll bet they’d tell you it sure feels a lot worse than that. And they’re actually right in a way; the average stock was in a bear market before 2016 even started. And small cap stocks – the Russell 2000 – were down 27% at their low last week, well past the 20% barrier.
There isn’t much agreement on what is driving stocks down and as I write this the rest of the world is recovering strongly from last week’s downdraft. Japan, which led on the way down, was up over 7% last night which unfortunately still leaves it well short of where it started last week. And Europe is rallying as Mario Draghi once again promises to do something, anything when the ECB meets. That despite the notable lack of success he’s had stimulating the corpse that is the European economy so far. Safe havens, bonds and gold, are selling off in the futures markets.
So, is that it? Down 20% and we’re all done? Central bankers have suddenly recovered their credibility? Policies that last week scared folks to death are this week going to generate the recovery we’ve all been waiting for? Yeah, seems unlikely to me too. Bear markets, like their bull market cousins, don’t move in straight lines and if we bounce this week it is probably nothing more than a rally in a developing and not fully completed downtrend. That doesn’t mean it can’t be a strong rally or one that the brave can trade. Some of the biggest rallies in market history have actually happened within the context of bear markets.
But I suspect this bear market has more to go. All the market indicators are still pointing to more downside. The yield curve is still flattening, the long end of the curve outracing the short end. Bond yields, nominal and real, are falling, growth and inflation expectations diminishing. We might get a few days or even weeks of rising yields but the trend globally is inexorably toward lower and lower rates. Negative rates in Europe and Japan don’t seem to be having any positive impact – indeed maybe the opposite – but that didn’t stop a discussion of the possibility in Yellen’s testimony last week. Credit spreads are still blowing out, the lowest rated paper now yielding 20% above Treasuries. There isn’t a lot of lending going on in the junk space and certainly not at those usurious rates.
The world’s central bankers seem to be living down the rabbit hole of monetary theory, believing as many as six impossible things before their next meeting, running as fast as they can just to stay in place, their imaginations the only weapon in the war against reality. Negative interest rates are intended to force banks to lend despite a lack of worthy borrowers, something quite inimical to bank shareholders’ best interests and rapidly reflected in bank share prices. Central bankers, despite Janet Yellen’s protests to the contrary, also seem to have forgotten about the interests and actions of savers in this brave new world. Low interest rates may be a boon to the debtor but only serve to remind the saver how much more he has to put away to reach his goals. Not exactly the fillip to aggregate demand the Keynesian playbook envisioned.
With all the emphasis by central bankers in recent years on their communication policies, I am baffled that they don’t seem to understand the message sent by negative rates. What it says quite loud and clear is that the central bank believes its currency too valuable and is set on doing something about it. What other message could possibly be intended when the policy threatens to destroy the value of deposits at the central bank? The message to bankers is lend this money to someone who will destroy it or we will destroy it for you. Now, surely that isn’t the message the central bankers intend to send but it is certainly the one received by the market. That the yen rallied after the BOJ’s actions is irrelevant. That is not, as I’ve seen so many articles state recently, a flight to safety. Why would anyone choose a country with a debt to GDP ratio of 250% and an explicit policy of devaluation as a “safe haven”? The rally in the yen is an unwinding of a carry trade, the funding of risk positions through yen loans. It is the selling of the hottest, most crowded trade of the last few years, long Japanese stocks/short yen through an ETF like N:DXJ. People are selling Japanese stocks and other risk assets because central bank policies globally are inimical to growth and getting worse not better. Better to put your money in gold or some other asset that will hold its long-term value while you wait out the bad economic policies.
The politicians aren’t helping any either. President Obama offered his budget last week, an unserious document with no chance of passing. It is a political document with policies that wouldn’t pass a Congress controlled by his own party much less the opposition. People notice when the leader of the country just punts on economic policy in favor of making political statements in an election year. The odds of getting any serious work done on the budget this year was slim to begin with but this was just finger in the eye of the US economy.
The candidates to replace President Obama offer no more comfort from either side. The xenophobic and protectionist offerings of the leading Republican candidates stokes the fire of the already heated currency wars. On the Democratic side Hillary Clinton is beset by scandal and pulled constantly to the left by the populist/socialist Sanders, who gives a whole new meaning to the phrase “big government”. Politics is just scary right now and I think most reasonable people would agree with that regardless of political affiliation. Surely neither side is comfortable or happy with the choices they have in the Presidential primaries. At least I’m not; I probably shouldn’t speak for others.
With monetary policy in disarray, struggling to find a policy that will do the impossible, that will overcome the structural problems produced by a dysfunctional political system and the political system showing no signs of changing, is it any wonder that the economy and markets are struggling, that the bear stalks Wall Street? If the problem were confined to one country, we might be able to adjust our investments, shift our funds to countries with better policies. But the monetary, fiscal and political dysfunction is in many ways global. Europe and Japan have much the same problems as the US, from aging populations to demonizing of immigrants to arrogant central bankers. China is discovering the limitations of the socialist, top down approach to economic planning, ironically just as the US has decided to shake off the taboo of the word and consider the possibilities of more government control.
The irony of all this is that the answers to most of our problems are for policymakers to do less not more. Economies do not need and cannot function with negative interest rates. Individuals and companies cannot plan for the long term with volatile currencies; a truce needs to be called in the currency wars. Politicians need to reduce the government footprint on the economy, simplify the rules and regulations, throw the cronies out of capitalism, make their countries friendly places for companies to invest and install tax systems that favor simplicity over social goals. Do less and the economy will do more.
The problem with the economy and markets right now can be summed up in one word – fear. Negative interest rates say pretty loud and clear that things are not normal, that there is something still pretty drastically wrong with the global economy. The political dysfunction that has plagued the country for 15 years has reached its logical, ridiculous conclusion with the current frontrunners in the Presidential contest. It is dispiriting, a pessimism fed by a feeling that the people in charge really don’t have much of a clue what they are doing. The world needs a breath of fresh air, a dose of optimism to escape this global ennui.
The US economy is not terrible, we are not headed for economic Armageddon. But neither is it as good as it could be, not by a long shot. We Americans are a naturally optimistic lot and it would not take much to get us out of our funk. But we need to feel that the rules are fair, that they apply to everyone and each person has an equal chance to succeed. I don’t think that’s the way most people feel right now. We papered over our economic problems for a while with easy money, but it appears the bill is coming due once again. Unfortunately, it appears the only answers we’ll be getting will be from the central bankers, at least until after the election. QE 4? Negative rates? Something else? I don’t know, neither does anyone else and that is the problem in a nutshell.
I suspect the Fed will be forced – or more accurately will feel forced – to respond to the rest of the central bank moves. The dollar seems to be telling us that already having peaked almost a year ago. Gold is picking up and if the dollar follows through to the downside, other commodities will likely follow. I don’t think we’re there just yet, but our economists, our central bankers were educated the same as Japan’s and Europe’s; they will pursue a weaker currency even if they don’t call it that explicitly. And right now, a weaker dollar would be welcomed by most of the world so don’t expect much resistance to the idea. Investors need to shift their thinking 180 degrees and start anticipating and investing for a weaker dollar world.