Download GLOBAL ECONOMIC ALERT on European Negative Interest Rates

GLOBAL ECONOMIC ALERT on European Negative Interest
Rates
A Negative plus a Negative Does Not Equal a Positive
By Mark Donnelly, CFA, CFP®, MSF
April 5, 2016
Key Highlights:
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In December of 2015, after seven years of zero short-term interest rates, the Federal Reserve finally
changed direction with their first increase in almost ten years
More than a year and a half after the European Central Bank instituted negative short-term interest
rates, the Japanese Central Bank followed suit in January of 2016
Most recently, the European Central Bank has moved further into negative interest rate territory and
has also instituted a program to essentially pay its banks to lend money
Investment returns will diverge across different investments, but in general markets should continue
to perform well for the next twelve to eighteen months.
We’re most concerned about the long-term effects that these unconventional central bank policies
could have in creating another destabilizing bubble in the global economy
Global Central Bank Policy Diverges
On March 10th the European Central Bank announced it will move further into unconventional territory by
promoting negative interest rates and paying banks to lend money to borrowers. This is their latest monetary
policy response to try to combat poor economic growth. We believe this is a step too far. We think a year or
two from now negative interest rates are likely to prove to have been a poorly conceived notion, while
incentivizing bank lending by paying banks to lend will certainly prove to be so.
The U.S. Federal Reserve made an important, small, step away from zero interest rates back in December in
a move that we applauded as a step in the right direction – even if it was a very small step. A continuance of
this process is very important to return our economy back to a state of normalcy, where savers are at least
paid something for their efforts.
The problem is that we’re further along on our road to recovery than other globally important economies in
Europe, Japan, and China. So, while the U.S. Central Bank is moving its monetary policy in what can now be
considered the right direction (when the starting point is zero or lower), most others are not. In particular, the
European Central Bank, through the leadership of Mario Draghi, has made it clear that they’re willing to stop
at nothing in their efforts to stimulate economic growth. That has been their unwavering goal, to show that
they’ll do whatever it takes. Whatever it takes is leading them down a dangerous road that could be laying the
foundation for another financial crisis. And now, through their actions, they’ve encouraged Japan to follow in
their footsteps.
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Central banks have been trying for years to fill the void of an inadequate government response to many of the
same problems that are being felt around the world. Problems related to both governments and consumers
trying to get back on track after taking on too much debt leading up to, and immediately following, the Financial
Crisis in 2008. We’re still nursing an economic hangover from this catastrophic event.
Central banks have been fighting this battle alone as politicians have been both unable and unwilling to make
the hard decisions that will get our economies back on track. There’s been a distinct lack of leadership on the
most important issues facing our economies. We desperately need some leadership in our governments, and
soon, as central banks have more than done their part. They’re now trying to do far too much because of the
isolated position they’ve found themselves in since the Financial Crisis.
Where Could This Lead?
Unless government officials at home and abroad are able to get their act together and enact the reforms that
are needed to fix our economies rather than having their central banks paper over the cracks, we’re headed
for a dark place. We had a taste of where this could possibly lead back in 2008, and there have been additional
blips that indicate we’re heading back there again unless action is taken and soon.
Biotechnology and Oil and Gas Exploration and Production Bubbles
Over the past year and a half we’ve had two areas of the market that have struggled considerably. Most
recently it’s been the Biotechnology sector of the market, which after rising almost 300% over the past five
years, fell close to 50% over the past eight months.
The U.S. energy sector has also been struggling and for even longer. Since oil prices first started to fall in
June of 2014 the energy sector has performed very badly indeed. The energy sector as a whole fell almost
50% and the Oil and Gas Exploration and Production subsector fell over 70% since June, 2014. The biggest
reason for the drop in oil prices and other energy sources has been a general overinvestment in the energy
sector, in particular in oil production here in the U.S. This has led to a dramatic oversupply of oil which in-turn
caused the price to fall significantly.
Many oil and gas production companies will go out of business over the next 12 months, and investors in this
area of the market have been especially hard hit. Fortunately, we chose not to invest heavily in any of these
areas, avoiding biotechnology stocks and choosing to be underweight the energy sector for quite some time
now – in contrast to many of our peers.
In addition to these two areas of the market, we’ve also avoided the whole commodity asset class, which has
fallen 58% over the past 5 years. We’re now looking at commodities as an opportunity for future investment
given the time frame and severity of its poor performance.
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Biotechnology Performance
Source: Bloomberg
Oil and Gas Exploration and Production Performance
Source: Bloomberg
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Commodities Performance
Source: Bloomberg
Biotech and oil and gas exploration and production are relatively small areas of the total stock market
(although energy does represent over 6%) and the overall U.S. economy, but the expansive monetary policy
that the Federal Reserve has been beholden to for so many years hasn’t helped to prevent against these
types of bubbles. It’s added fuel to the fire. The good news is that they’re gradually trying to move away from
this policy; the bad news is that they’re now a minority player in the group of central banks.
Our biggest concern is that if this excessive central bank interference is allowed to continue for too much
longer, these mini-bubbles will turn into much, much bigger bubbles with the potential to knock our economy,
and the global economy back to where we were in 2008 – or even worse because we’re not strong enough
to take another shock to the system like that.
We monitor a number of indicators of global economic health to determine if we’re getting closer to a 2008
type event, and while few are currently ringing any bells for a recession we do worry that we’re now sowing
the seeds of the next crisis.
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Indicators that we monitor to help us paint a picture of global economic health are:
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Employment Trends - Almost all positive and moving in the right direction
o Hiring
o How many people are quitting for better opportunities
o Wage growth
o Job cuts
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Consumer Trends - Generally positive, most moving in the right direction
o Consumer confidence
o Personal spending
o Retail sales
o Total vehicle sales
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Housing Trends – All positive and moving in the right direction
o New and existing home sales
o Building permits (builders applying for approval to build homes)
o Housing starts (builders start building new homes)
o Mortgage applications
o House price appreciation
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Inflationary Trends – Minimal evidence of excess inflation in the economic system at this time, which
gives central banks more options
o PPI – Producer Price Index (measures change in selling price over time for producer goods)
o CPI – Consumer Price Index (measures price changes in consumer goods and services)
o PCE – Personal Consumption Expenditures (similar to CPI, it measures price changes in
consumer goods and services)
o Wage Growth
o Unit labor costs (change in cost per unit of labor)
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Economic Growth – Mixed, equal positives and negatives (likely a short-term rough patch given
other indicators)
o Strength of manufacturing
o Strength of non-manufacturing
o Regional strength
o Capacity utilization (how much of potential output levels is being used)
o Consumer credit growth
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Market Level of Risk – Elevated risk driven by central bank actions and oil prices concerns
o High yield credit spreads (how much additional compensation you get for owning riskier
assets, the higher it is the higher the risk)
o Slope of the yield curve (short-term interest rates versus long-term interest rates
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Bank lending standards (become tougher and less likely to lend when they perceive higher
risks in the markets or have less ability to lend)
Stock and bond market volatility (how quickly and how significantly they move up and down,
more quickly and more significant moves mean higher risk)
Central Bank Policy – Positive for economic growth, a concern for long-term stability
o The biggest wild card, as it can be a guessing game of if/when they’ll make moves, but their
moves have had more effect on investment markets over the past 7 years than all of the above
indicators combined
What’s Next?
It’s a good sign that we’re heading back towards a normalized interest rate environment in the U.S. after
almost seven years stuck in an abnormal state with zero short-term interest rates. It’s an indication that the
economy has recovered to the point that it can now stand, unaided on its own feet after being propped up by
the Federal Reserve for such a long time. An improving economy is good for investment markets and good
for portfolio performance.
If the European Central Bank and Japan don’t follow suit soon and begin to reverse course on negative
interests rates, then sooner or later another bubble will form that could be of a similar magnitude to what we
lived through in 2008. We don’t know when this will happen, but we’re relatively certain it will happen if there
aren’t any changes to this ill-conceived central bank policy method.
We’re keeping a watchful eye out for signs of potentially portfolio destructive events to minimize any impact
as much as possible, as we have done recently with the Biotechnology and energy sectors. We’re following
our own internal indicators and looking for further signs of bubbles starting to build and will act accordingly if
we perceive the risks to be too high.
We do want to highlight that we believe problems aren’t currently imminent, but want to keep you informed on
what our biggest concerns are as they develop. Looking out one to two years from now we are beginning to
get wary of where our central banks are leading their respective economies and investment markets. We’ll
continue to keep you updated as this important issue progresses.
Please contact your AEPG financial life planner if you have any questions or concerns on this subject or any
other.
Important Disclosures: Please remember that different types of investments involve varying degrees of risk, including the loss of money invested. Past
performance may not be indicative of future results. Therefore, it should not be assumed that future performance of any specific investment or
investment strategy, including the investments or investment strategies recommended or undertaken by American Economic Planning Group, Inc.
(“AEPG”) will be profitable. Definitions of any indices listed herein are available upon request. Please remember to contact AEPG if there are any
changes in your personal or financial situation or investment objectives for the purpose of reviewing our previous recommendations and services, or if
you wish to impose, add, or modify any reasonable restrictions to our investment management services. This article is not a substitute for personalized
advice from AEPG and nothing contained in this presentation is intended to constitute legal, tax, accounting, securities, or investment advice, nor an
opinion regarding the appropriateness of any investment, nor a solicitation of any type. Investment decisions should always be made based on the
investors specific financial needs, objectives, goals, time horizon, and risk tolerance. Please remember to contact AEPG Wealth Strategies if there are
any changes in your personal or financial circumstances or investment objectives as these changes may impact our previous recommendations. This
information is current only as of the date on which it was sent. The statements and opinions expressed are, however, subject to change without notice
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discussing our advisory services and fees is available for your review upon request.
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