Below the Zero Bound

Below the Zero Bound
Monday, February 1, 2016
See the pdf and the collection of the individual charts linked below.(1) Short-covering and relief rally. (2) January Barometers and Presidential Cycles. (3) BOJ crosses the zero bound. (4) Bernanke says negative interest rates could be a Fed tool. (5) Williams says normalization should be slowed a “smidgen.” (6) The horror of negative rates driving investors back into stocks? (7) Measuring how much the Fed has already tightened. (8) Dudley’s faith in economy not so sound. (9) GDP adding up to more of the same slow growth in 2016 as every year since 2010. (10) “Room” (+ +).

Strategy: Barometers. Despite Friday’s impressive rally, the S&P 500 was still down 5.1% during January (Fig. 1). Five sectors outperformed, and five underperformed as follows: Telecommunication Services 5.5%, Utilities 4.9, Consumer Staples 0.4, Energy -3.1, Information Technology -4.9, S&P 500 -5.1, Consumer Discretionary -5.2, Industrials -5.8, Health Care -7.7, Financials -9.0, and Materials -10.6.

Not surprisingly, during Friday’s rally the month’s big losers recovered the most while the winners lagged, suggesting lots of short covering: Information Technology 3.6, Materials 2.9, Financials 2.9, Industrials 2.8, Energy 2.6, S&P 500 2.5, Consumer Staples 2.1, Utilities 1.9, Telecommunication Services 1.8, Health Care 1.7, and Consumer Discretionary 1.2.

On Wednesday, January 20 (the same day I stayed in Room 666 in the Zurich airport hotel), the S&P 500 crashed 69 points to 1812.29 on an intraday basis, before staging an impressive rally closing at 1859.33, matching the two previous closing lows since late 2014 (Fig. 2). On Monday, January 25, I wrote that “Joe and I believe that it may be too late to panic and that Wednesday’s action might have made capitulation lows in both the stock and oil markets.”

It’s certainly too soon to declare victory, though the S&P 500 was back up at 1940.24 on Friday. After all, on Thursday, August 27, two days after the S&P 500 tumbled on Monday and Tuesday, Joe and I also declared that the worst was over. It was a good call until January’s grizzly bear attack. And now we have to contend with the January Barometer. According to ancient market lore: As goes January, so goes the year. There’s also the Presidential Cycle, where the fourth year of presidential terms can be more troublesome than the others because of the uncertainty surrounding the election at the end of the year. Consider the following:

(1) The January Barometer is arithmetically biased to work since it gets a one-month head start on the year’s outcome. Of course, this year has a big head start on the downside. In the 88 years since 1928, there have been 33 down Januarys, with 58% correctly predicting a down year. So the January Barometer gave a false reading 42% of the time. Since 1950, there have been 26 down Januarys, with 54% correctly predicting down years (Fig. 3).

By the way, let’s recall that last year ended in “5.” The previous fifth years of the past eight decades were all up, with an average gain for the S&P 500 of 25.3% (Fig. 4). Last year, the index was down 0.7%. In other words, stock market barometers are much less reliable than weather ones.

(2) The Presidential Cycle is another questionable predictor of stock market performance. The third year of presidential terms has had the best average return of the four years that compose a term, with an average gain of 12.8% since 1928 (Fig. 5). Of the 22 third years, 77% of them were up by 19.7% on average. However, 23% of them were down by 10.7% on average. Last year was another downer. This is the fourth year of the Presidential Cycle, with an average gain of 5.5% (Fig. 6). Of the 21 fourth years, 71% were up by 13.2% on average and 29% were down by 13.8%.

Of course, stock investors may also have been increasingly rattled by the current presidential campaign. I certainly wouldn’t lay odds on its outcome. The current campaign for the White House has been wackier than most, with the leading contenders on both of the opposing sides agreeing that Wall Street is the real enemy of the people. (See our Presidential Cycles.)

Joe and I tend to focus on the fundamentals that drive the stock market. While we also monitor technical indicators and barometers, we don’t give them as much weight in our analysis. However, we feel more comfortable with our fundamental view if it is corroborated by the technicals.

The latest fundamentals are mostly showing a continued slowing in the global economy, though the jury is still out on whether it is heading toward a recession. We don’t think so, and we think that S&P 500 earnings can grow about 5% this year and next year. The technicals have been mostly bearish since last year as the breadth of the bull market narrowed. On the positive side is that sentiment indicators have been so bearish that they actually are quite bullish from a contrarian perspective.

Central Banks: Going Negative. Following its apparent capitulation reversal on Wednesday, January 20, the market continued to rally on Thursday, January 21, on news that ECB President Mario Draghi promised more monetary easing if necessary by March. At the beginning of his prepared remarks during his 1/21 press conference, Draghi said:

“Yet, as we start the new year, downside risks have increased again amid heightened uncertainty about emerging market economies’ growth prospects, volatility in financial and commodity markets, and geopolitical risks. In this environment, euro area inflation dynamics also continue to be weaker than expected. It will therefore be necessary to review and possibly reconsider our monetary policy stance at our next meeting in early March, when the new staff macroeconomic projections become available which will also cover the year 2018.”

Since the start of the year, there have been widespread fears that the central banks may have run out of ammo. I wrote on January 25, “Apparently, they haven’t run out of fairy dust, which still has the power to give global stock markets a high.” That was evidenced again on Friday, when the Bank of Japan unexpectedly joined the ECB in lowering its official lending rate below zero for the first time ever, to -0.10%, though only on new bank reserve deposits. The ECB first cut its rate on all deposits on June 11, 2014, lowering it to -0.10% (Fig. 7). The Eurozone’s central bank cut the rate again to -0.20% on September 10, 2014 and most recently to -0.30% on December 3, 2015.

Not surprisingly, the yen dropped, and the Nikkei 300 soared 3.0% on the BOJ’s surprise move (Fig. 8). But why did US stocks soar given that more easing by the ECB and BOJ should continue to send the dollar higher, which can’t be good for the US economy and corporate profits? Indeed, on Friday we also learned that US real GDP rose just 0.7% (saar) during Q4-2015. The day before, December’s US durable goods orders report showed a big drop of 5.1%, led by a 4.3% plunge in nondefense capital goods orders ex aircraft, a very good indicator of future business investment.

Stock and bond investors may be coming around to our viewpoint that the Fed is very unlikely to raise interest rates four times this year. Even one rate hike is looking less likely. Consider the following:

(1) Fed next? Investors obviously don’t believe that the Fed will be hiking the federal funds rate anytime soon. On the contrary, they may be worrying that the global economic slowdown is already depressing US economic growth. It’s increasingly conceivable that the Fed might actually have to reverse course. It’s even conceivable that the Fed will eventually resort to negative interest rates. Former Fed Chairman Ben Bernanke has said that this is exactly what the Fed might have to do to avoid the next recession.

(2) Fed heads. Now that the latest FOMC meeting is over, we undoubtedly will be hearing lots of chatter from the members of the Federal Open Mouth Committee about all of this. FRB-SF President John Williams started out the year, on January 4, predicting that the FOMC would be raising the federal funds rate four to five times this year. A week and a half later, on January 15, he said that a slowdown in China spilling over to the US is keeping him up at night. This past Friday, he told reporters: “Standard monetary policy strategy says a little less inflation, maybe a little less growth … argue for just a smidgen slower process of normalizing rates.”

(3) Clipped coupons. The FT reported that there are now $5.5 trillion in government bonds with negative interest rates in Japan and Europe. That’s pushing US bond yields down, with the 10-year falling to 1.94% on Friday. We’ve been forecasting that this yield would continue to range between 2.00% and 2.50% this year, as it did most of last year (Fig. 9). We are lowering the bottom of this range to 1.50% now.

As long as the US economy doesn’t fall into a recession, low bond yields should be bullish for stocks. They tend to fuel buybacks and M&A, and to boost valuation multiples. The possibility of negative interest rates in the US now that both the Eurozone and Japan have them is bound to make more investors conclude that owning investment-grade bonds and blue-chip dividend-yielding stocks is their only hedge against the horror of possibly earning a negative return on government securities!

(4) Measuring tightening. The Fed is facing mounting criticism that the rate hike at the end of last year was a big mistake. A few economists already are comparing it to the Fed’s tightening mistake in 1937. Last year, Larry Summers warned against doing so. More recently, Jeff Gundlach has been predicting that the Fed might have to reverse the move and even restart QE.

Debbie and I have argued that the termination of QE at the end of October 2014 combined with all the chatter about “liftoff” that followed–culminating in December’s 25bps rate hike–caused the dollar to soar by more than 20% since the summer of 2014. In our opinion, that’s equivalent to a rate hike of 50-100bps. According to one econometric study, the termination of QE amounted to a 300bps tightening, with the federal funds rate effectively rising from minus 3% to zero as a result.

Fed officials insisted that terminating QE wasn’t monetary tightening, just less monetary accommodation. However, they seem to have forgotten that they justified QE2 by saying that their econometric model showed that the economy needed a federal funds rate of -0.75%. At the time, the Fed and other central banks still believed in the quaint notion that rates couldn’t be lowered below the “zero bound.” However, Fed officials maintained that they in effect could lower the federal funds rate to -0.75% with a QE2 program of $600 billion in bond purchases, which started on November 3, 2010 and ended on June 29, 2012. That was followed up by purchases of another $40 billion per month under QE3, starting on September 13, 2012, which was followed by QE4 on January 2, 2013. That increased the purchasing to $45 billion per month; it was terminated on October 29, 2014, when the Fed’s balance sheet peaked at $4.5 trillion, up $1.7 trillion since the end of QE2 (Fig. 10).

So the conclusion that ending QE amounted to a significant tightening makes sense if you believe that all the QE programs amounted to a significant easing, effectively lowering the federal funds rate to -3.00%. We are skeptical, mostly because we never bought the idea that QE did much for the economy. In any case, it isn’t hard to conclude that the Fed has tightened enough since it terminated QE and that none-and-done is a real possibility this year.

US Economy: Sound Footing? I’ve always told my five children that it is better to say nothing than to say something foolish. That’s the advice I would give the members of the FOMC, starting with Williams. My hunch is that FRB-NY President Bill Dudley already must regret telling an audience on January 15 that the US economy is on “sound footing” and better able to “withstand downside shocks.” He also said that he is “very pleased by how well” the Fed’s policy tools are working. Two weeks later, the latest releases for durable goods orders and GDP suggest that the economy’s footing isn’t so solid. Let’s reassess our own outlook for the economy based on the latest batch of somewhat unsettling data:

(1) GDP: Growth. We are forecasting that real GDP will increase 2.3% on a Q4-Q4 basis this year, up from 1.8% last year. On this basis, real GDP has been growing around 2.0% since mid-2010 (Fig. 11). Historically, 2.0% has been the “stall speed,” which inevitably was followed by a recession. That hasn’t happened so far, though real GDP growth was back below this speed at 1.8% last quarter.

We are counting on fiscal stimulus to boost economic growth this year. Government spending in GDP was mostly a drag on economic growth during the current economic expansion. (The government’s entitlement programs redistribute income and are not directly reflected in GDP.) The recent budget deal in Washington suggests federal government spending will boost growth. The same is likely at the state and local government level, though some of the oil-producing states may have to cut their spending as their revenues from their oil industries dry up.

(2) GDP: Consumer & housing. We also are forecasting that real consumer spending will grow around 3% this year, the same as last year. Employment growth should remain solid. Wage gains may remain relatively low around 2.5%, but still outpace consumer prices, especially if gasoline prices remain low. Consumer spending did slow during Q4 to 2.2% (saar) from 3.0% during the previous quarter. However, some of that weakness was attributable to unseasonably warm weather, which depressed spending on energy nondurables and services.

Another positive contributor to real GDP this year should be residential investment spending. Rising household formation should continue to boost housing construction. Multifamily starts have been booming as landlords build more units because rents are rising so rapidly. High rents should stimulate more first-time home buying. In our scenario, mortgage rates are likely to remain affordably low all year.

(3) GDP: Capital spending & orders. Last week’s big shocker was the 4.3% plunge in nondefense capital goods orders excluding civilian aircraft (Fig. 12). That doesn’t augur well for capital spending, which fell 1.8% (saar) in Q4’s real GDP, the first negative contribution from this component in 13 quarters. It could continue to weigh on growth this year as capital spending is slashed by energy and mining companies around the world. In addition, the strong dollar is depressing all exports, including those of capital goods exporters.

(4) GDP: Trade. During Q4, real final sales rose 1.2% (saar), exceeding the 0.7% increase in real GDP. The problem is that exports fell 2.5% while imports rose 1.1%. The strong dollar is certainly depressing the former while boosting the latter. In addition, the global economic slowdown has weighed on US exports. Trade is likely to continue to be a negative contributor to US growth this year. However, that means that the US should be an important source of growth for the rest of the world.