March 2016 – Monthly Commentary
The first quarter of 2016 was dissimilar to the first quarter of last year in many ways, except that both periods felt as though the U.S. was at risk of slipping into recession. Last year’s dreadful winter weather brought economic activity to a standstill in the Northeast and the ongoing West Coast Port strike slowed growth in the west. Gross Domestic Product for the period was originally reported as contracting before being revised to a meager 0.6% annualized gain. The weather this year was unseasonably warm and snowless allowing construction, transportation, and general economic activity to continue unabated throughout the winter. The recession threat this year was, instead, investor manufactured. Last year we worried that the Fed engineered rate hike in December would have an adverse effect on the markets during the liquidity constrained holiday period. Instead, investors waited until the first day of the New Year to panic and dump stocks. The selling continued into February as investors digested the Fed’s forecast for four rate hikes in 2016. The panic culminated in February when the specter of a European banking crisis briefly resurfaced. European Central Bank Chairman Draghi stymied the selling with his announcement that the ECB would effectively double their quantitative easing program and expanded their asset purchases to include non-financial investment grade corporate debt. Since reaching the nadir, the S&P 500 came roaring back to close Q1 at 2,063, just below the 2,084 level at which the index closed out the first quarter of last year.
That 200 point round-trip in the index and the corresponding volatility in the commodity and foreign exchange markets must have worried Fed Chair Yellen. She went from confidently communicating the beginning of the rate normalization process in December to sheepishly describing the risks buffeting the U.S. economy at the post-meeting press conference in March. She offered a laundry list of worries, including continued slow economic growth in Europe, China, and Japan, the deflationary impact of falling oil prices, and the economic challenges posed by a strong dollar. The accompanying statement indicated that the FOMC had reduced the anticipated number of rate hikes from four to two this year. Despite that forecast, she inadvertently suggested that only one rate hike would be in the cards in 2016. Speculating on her thinking, it seems to us that she must have been severely shaken as stock prices cratered, fearful that her vote to raise rates might have reignited a new financial panic. From that perspective, we hypothesize that she wanted investors to understand that she was aware of their concerns and that she wouldn’t do anything to disappoint them.
Despite her “dovish” press conference, we imagine the open market committee meeting was a contentious one, with Yellen defending her decision to the regional Presidents who have argued that interest rates no longer need to be maintained at crisis levels. That’s a salient point that we’ve made on many occasions. With core consumer price inflation rising 2.3% annually, an investor holding the five-year treasury, which currently yields 1.14%, is destroying the value of their investment by more than 1% a year.
To follow-up on the European Central Banks intention to purchase non-financial corporate bonds, we worry that they are likely to encounter a host of unintended consequences. In buying corporate debt, they will be taking a position in the capital structure of publicly traded companies. One could argue that in doing so, they’re interfering in relative competitiveness of the corporate landscape. Which companies will be the beneficiaries? Will demand for corporate debt be met with additional supply? Will the additional supply be so large as to cause a deterioration of the credit quality of the entire sector? Those are just a few of many questions that remain unanswered regarding the operation. On the other hand, how would the central handle a corporate credit that had deteriorated and was at risk of being downgraded. If their policy would be to sell on the downgrade, it seems to us that investors would move to sell before the ECB and could quite possibly hasten a down grade or worsen the selloff. It’s as though having a negative interest rate term structure and printing 85 billion Euros a month is not bad enough policy. To ensure that they inflict maximum distortion on their economy, they are now in the credit allocation business. There may very well be significant negative consequences!