As we wrote last month, illiquidity and investor nervousness wreaked havoc on the junk bond market as investors attempted, en masse, to liquidate their junk holdings. That nervousness carried over into the broad capital markets in October in trading that was reminiscent of October 2008. The economy is clearly on solid footing and the necessity of a zero interest policy has long passed. Nonetheless, we expect that our perseverance will soon be rewarded as interest rates normalize.
During the month, a confluence of factors prompted traders to hit the panic button and shed risky assets, beginning with Bill Gross’ sudden departure from PIMCO. News crossed that nervous investors were liquidating their PIMCO holdings and that selling widened credit spreads marginally as dealers were reluctant to take the other side of the selling. Continuing economic malaise in Europe and the possibility that it would drag export stalwart Germany into recession also weighed on the collective psyche of the market. Adding to the dissonance, debate abounded about whether the falling price of crude oil since early summer reflected weakness in global growth (bad news) or the growing influence of North American production on energy supply (good news). Those fundamentals were more than enough to pressure stock prices, but when news broke that the deadly and presumed incurable Ebola disease reached the United States, near panic ensued. With media coverage bordering on hysteria, fear grew that a pandemic would develop and healthcare officials were helpless to prevent it. Investors began to calculate the impact to profits if people were afraid to congregate or to travel by train, plane, or ship and concluded that the downside could be substantial. The selling was steepest on October 15th when the S&P 500 had a month-to-date loss of 7.7% and the 30-year U.S. Treasury bond had an intraday high that was nearly six points higher than the opening price. The panic was exacerbated by news that primary dealers of U.S. government bonds turned off their electronic execution systems to avoid selling bonds in a rapidly rising price environment. The panic was halted in its tracks by St. Louis Federal Reserve President James Bullard. While generally considered hawkish on monetary policy, Bullard said in an interview that the Fed could consider postponing the end of quantitative easing given weakness in the markets and the failure of inflation to rise above 2%. Traders took that to mean that the Fed would consider a continuation of their easy money policy and, at the very least, delay the commencement of a rate hike. Stocks rallied sharply as the panic began to subside. Further calming the markets was news that the early Ebola victims had been cured and were back to living a healthy life. The return of greed was so swift and complete that the stock market barely flinched when the Federal Open Market Committee delivered a more hawkish assessment of the economy than was expected at the conclusion of the October 29th meeting.
However, the most shocking news of the month came early Halloween morning, as the Bank of Japan (BOJ) announced that they would expand quantitative easing from approximately $570 billion to $700 billion a year, in Yen terms. Moreover the BOJ stated that most of the increase in newly printed Yen would be used to purchase Japanese Government Bonds (JGB) and the target duration of the purchases would be increased to 10 years from the current 7 years target. In addition to JGB’s, the BOJ announced that it would increase its purchase of exchange traded equity funds and Japanese real estate investment trusts. Simultaneously, the Japanese Government Pension Investment Fund (GPIF) announced changes to its asset allocation. Specifically, the $1.25 trillion GPIF announced that they intended to increase their domestic equity allocation to 25% from 12%; the non-Japanese equity allocation to 25% from 12%; the Non-Japan fixed income allocation to 15% from 11%; a reduction of the domestic government bond allocation to 35% from 60%; and the cash allocation to 0% from 5%. In working through the arithmetic, the fund will be upping their domestic and international equity allocations by approximately $165 billion each and reducing their holdings of JGB’s by a whopping $317 billion. Equity markets around the globe spiked higher on the news as investors sought to buy equities before the Japanese government executed their orders. In our opinion, this is clearly a “Hail Mary” attempt to sharply devalue the Yen and improve the Japanese export sector and not a “new policy asset mix…compatible with the changes in long-term economic prospects” as it was described in the GPIF press release. BOJ Chairman Kuroda cited the falling price of oil as a factor in the policy moves. His rationale, which strikes us as deeply flawed, is that the drop in oil prices will result in an unwanted fall in CPI, which will have a psychologically negative effect on retail spending. Seemingly, Kuroda believes that the added discretionary income coming from falling energy expenditures will be saved not spent, but if the consumer price index is rising, consumers will be more eager to spend. Hence a weaker yen will offset that falling price of oil in the inflation calculation and make Japanese goods cheaper on the world market. We believe he is likely to get his wish for a weaker currency, even from the recent highs, but fear that the rising cost of crude oil, Japan’s largest import, will sap the spending power of its citizens which, in turn, will result in even less consumption. In that, we see the move as a risky one for the Japanese.