4th March 2016
So far in 2016, talk of negative interest rates in the US and Japan has been the root cause of much of the markets’ concerns. Renewed central bank interest in the topic seems to have emanated from Stanley Fisher at the Davos forum in early January. Unsurprisingly it was shortly after this that the Japanese central bank announced the move to negative rates – a policy already unsuccessfully implemented in Europe. The immediate results have not been positive for either the Nikkei or the Japanese Yen (weaker equity market, stronger currency). The evidence from the US and Europe in particular, through weaker Service PMI numbers, are suggesting that the west is increasingly resembling Japan.
Many of the concerns have been focused on the banks – particularly in Europe. After a poor January there continues to be considerable negativity around the banking sector and disappointing earnings performance has not helped. However, in our view, the real issue is the depressed outlook for bank Return on Equity (ROE) which has been driven by wafer thin net interest margins (NIMs). Negative rates are fundamentally bad for NIMs and in addition, put considerable pressure on asset base, which is heavily invested in negative yielding sovereign bonds. China continues to be in the news for all the wrong reasons – there have been plenty of announcements without any definitive strategy for the markets to hold their caps to. As regards emerging markets / commodities, in general we have achieved some degree of stability and it will be interesting to see if it can be sustained. Market sentiment has never been worse towards EM, however valuations, in relative terms, have never looked better.
So what happens next? While the latest G20 meeting once again failed to deliver any meaningful, coordinated, policy response, we will surely get more support from central banks. Ideally this will not involve negative rates…… The current discussions about getting rid of cash are fundamentally related to keeping deposits in the banking system and not preventing crime or tax evasion. Going forward the outlook looks set for continued choppy markets, with downside risk to some expensive, developed market assets. The dominos appear to be falling – this might be news to some people but in reality this repricing of risk globally has been happening since 2011 with the decline in commodities. As central bank policies have becoming increasingly ineffective, western assets are starting to pay the price for policymakers’ inability to deal with the structural problems we have faced since 2008. Given the lack of liquidity in some capital markets we do expect sharp rallies and pronounced selloffs over the foreseeable future – but there is little in the way of positivity from a policy perspective for the market to get its teeth into. What is helpful, however, is to see some overcapacity being taken out in key commodity markets. US data in particular is not a disaster by any means, but one needs to be concerned that the employment data might not hold up for much longer at this late stage in the cycle. Wage pressures are not coming through yet which continues to be of concern.
As regards our fixed income strategies, they have not changed much. In terms of our corporate exposure, the bias remains towards lower duration securities. Our allocation to financials has always been based around issuers with solid balance sheets and bonds with strong covenants. In our Global Fixed Income Fund, for example, we tend to offset this exposure to some degree against our longer dated US treasury exposure. As we have maintained for some time, and as many will know, we have favoured long-dated treasuries. Given current market conditions, we don’t see a need to necessarily change that view at the moment. In 6/9 months’ time, should the markets give us the opportunity, we expect to be moving the credit related part of the portfolio into more defensive IG exposure and looking for names with free cash flow dynamics. By that time we would expect the yield curve flattening in the US to have played out and may look to reduce our exposure there.
By Steve O’Hanlon