The battalions assailing financial markets in 2016 have received reinforcements over the last few weeks. To the concerns about the Chinese renminbi, China’s economic growth, oil prices and corporate earnings (see “The opening weeks of 2016 in financial markets: Harbinger or hiccup?”), we can add doubts about the US recovery, an immigration-induced return of borders within Europe and the increasingly perverse effects of central bank monetary policy, in particular negative interest rates.
The latest salvo in the global currency wars — the Bank of Japan’s surprise decision, on 27 January 2016, to adopt negative rates on some bank reserves and the governor’s statement that there was no limit to the measures he could take — raised the odds that the ECB will move its deposit rate further into negative territory. Eurozone bank shares have plunged and risk premiums spiked as existing concerns over non-performing loans and bank restructurings are augmented by worries over the impact of negative rates on bank profitability via lower net interest margins. Federal Reserve Governor Janet Yellen’s comments that further US interest-rate increases might be delayed have weakened the US dollar and the corresponding boost Japan and the eurozone had been expecting to economic growth from stronger exports.
Exhibit 1: Credit spreads (aka risk premiums) have spiked recently
Sources: Barclays, J.P. Morgan, BNP Paribas Investment Partners, as at 11/02/2016. *USD-denominated sovereign bonds
Investors were already slightly troubled by the disappointing US GDP growth rate in the fourth quarter at just 0.7% when the ISM Non-Manufacturing index highlighted a weaker-than-expected services sector. While at above 50, the index showed continued expansion in the sector (which is far more important for the US economy than the manufacturing sector), the reading fell by 2.3 points from 55.8 to 53.5 when expectations were for just a 0.2 point drop. Payroll growth in January was also below expectations, although the number of jobs created was still significant (151 000) and wage growth remained strong at 2.5% year-on-year. As a consequence, economists lowered their expectations for US growth in 2016 from 2.4% to 2.0%.
Exhibit 2: Relative equity returns (green line) and interest-rate expectations (blue line)
Source: Bloomberg, MSCI, BNP Paribas Investment Partners, at at 11/02/2016
The modestly weaker data alone was possibly enough to prompt a more restrained tone from the Fed on further policy tightening, but the extreme market volatility made it almost certain. The change in outlook has perversely contributed to the volatility that worries the Fed. At the beginning of the year, many investors were betting on economic divergence between developed and emerging markets, as well as monetary policy divergence between the Fed and the other major central banks. Many were positioned accordingly with overweights in European and Japanese equities.
As expectations for a rise in US interest rates have waned, so has the potential for non-US equity markets to outperform. The relatively higher expected returns were premised on the continued strength of the US dollar against the euro and the yen. Tighter US monetary policy also relieved pressure on the ECB and BoJ to stimulate growth and inflation even further as the Fed was to some degree doing the job for them. Now that the Fed seems to be pausing, the dollar has sold off and investors wonder how the other central banks will respond. Either there is little more they can do (the idea that the banks are out of ammunition or at least the ammunition they have is the wrong kind for the problem) or else they can do more, but it is likely to be more harmful than helpful (e.g., negative interest rates). Either way, it appears that non-US central banks will not have much impact on corporate profits.
The underperformance of eurozone financials this year has been driven by the realisation that the dismantling of the investment banking businesses will be more costly and difficult than expected and that even eight years after the ‘great recession’, many banks in the region have not addressed their non-performing loans. But what triggered the revaluation of the industry’s outlook has been the prospect of a sustained period of negative interest rates. Though the ECB introduced this measure already in December, the surprise move by the Bank of Japan means that the ECB may now need to go even further, with unpredictable consequences for bank profits. Many banks still need to increase their capital buffers and it is not clear where the money will come from. As a result, earnings forecasts for the sector have fallen further than for any other sector bar energy.
Exhibit 3: Change in the next-twelve-month (NTM) earnings estimates, by sector, during the period between 04/01/2016 and 11/02/2016
Source: FactSet, BNP Paribas Investment Partners, as at 11/02/2016
The question for investors is whether the decline in prices has gone far enough to warrant moving back into the sector. It is not clear that they have. Current valuations are only part of the equation. There is now a premium that must be assigned to the sector to reflect the uncertain monetary policy outlook.
Multiples relative to expected earnings have fallen sharply and the sector is now trading on around eight times next-twelve-month earnings estimates. This is low for the sector, but it depends on what period one thinks is reasonable to compare it to. Banks are unlikely to return to the levels of profitability they enjoyed before the financial crisis, so the average multiples over that period of 12.2x are likely unattainable. The average multiple since 2008 has been 9.3x, which suggests banks are valued slightly below average, but are not cheap. Based on trailing price-to-book multiples, the picture appears similar: low relative to pre-crisis history, but not low for the world they are going to be operating in. One should also consider that book values, while more stable than earnings estimates, can rise as well as fall. The book-value-per-share for the MSCI UK banking index declined by 25% between 2008 and now, hence the current low multiple on the index may be deceiving.
Exhibit 4: Eurozone bank valuations
Sources: IBES, FactSet, BNP Paribas Investment Partners as at 11/02/2016
In contrast to last year’s market selloffs, which were triggered by inchoate fears about China, this time the market has fallen more or less in line with declining earnings expectations, meaning that valuations have hardly improved. A much bigger drop would be needed for multiples to reach the point where investors begin buying simply on price alone. But stability is unlikely to return to equity markets before the earnings outlook does the same and even at that point, equity markets may well recover only slowly.
Credit, on the other hand, be it investment grade, high yield or emerging markets, is likely to provide more attractive risk-adjusted returns over the medium term once markets stabilise. Even if spreads do not tighten quickly, they now offer higher yields than equities or sovereign (non-peripheral) bonds. The appeal of (investment-grade sovereign) emerging market debt depends on the outlook for Fed policy. If interest-rate hikes continue to be pushed off, the pressure on EM currencies should fall and markets should steady.
Another contrast with last year is the disbelief in the ability of the central banks to adopt any policies that could improve the outlook; in fact, the risk is that they make the situation worse. At least as far as economic growth is concerned, one can argue that the ECB has done as much as it needs to with the eurozone likely to grow by 1.6% this year, near its potential. Inflation expectations are the other worry, but as in the US (where core inflation is 2.1%), inflation should return on its own to the eurozone once oil prices stabilise. Patience will be rewarded.
Were the US economy to show renewed vigour and the market to again anticipate more Fed rate hikes, European and Japanese equities would likely regain their poise. There is, however, another, less benign, scenario where US interest rates rise. The latest payrolls report showed the unemployment rate falling to 4.9%. While the participation rate improved, it is unlikely to increase by enough to offset the rising pressure on wages. If compensation continues to increase while productivity lags, the Fed may feel compelled to hike rates and corporate profits will be squeezed.
Exhibit 5: Labour compensation and productivity
Sources: BEA, BNP Paribas Investment Partners as at 11/02/2016
Three scenarios present themselves at this juncture, with different implications for financial markets and investment. The scenarios are all centred on the US in the belief that the challenges facing Europe and Japan are structural at this point and are relatively immune to monetary policy measures. As Mario Draghi himself has said: “… we talk often about structural reforms … because we know that our ability to bring about a lasting return of stability and prosperity does not rely only on … monetary policy – but also on structural policies.” Reform efforts in the eurozone, however, seem to be lagging, not accelerating.
(i) Slower growth in the US (we believe the risk of a recession this year is still low), allowing the Fed to refrain from many more interest-rate hikes, would support returns for both equities and credit (investment-grade and high-yield (ex-energy)). This scenario would be negative for the eurozone and Japan, however, as their currencies would probably strengthen and their respective central banks may feel the need to counter this through yet more extreme monetary policies. At this point, negative rates or further quantitative easing will likely create only more market distortions and do little for economic growth.
(ii) An acceleration of US growth due to productivity gains would be the best global outcome as policy rates could rise in the US, moving monetary policy back towards normal levels, and the stronger US dollar would reduce pressure on the eurozone and Japan. The negative impact will be felt in emerging markets and therefore in Europe. Just as structural reforms are needed in the eurozone they are needed in emerging markets and they will be difficult to enact with oil prices low and currencies weak. It is an adjustment that has to take place, however, and the US is relatively insulated against it. During the Asian financial crisis, net exports dragged on US GDP growth, but that was driven more by a significant increase in US imports thanks to strong domestic consumption and investment than a collapse in exports. The eurozone, by contrast, is more exposed to emerging market turmoil. Over 20% of corporate revenues come from emerging markets (compared to less than 14% for the S&P 500) and most of the growth in revenues for eurozone companies has come from emerging countries, particularly China.
(iii) Strong payrolls growth and rising wages alongside a slowing services sector in the US highlight the risk of a mild ‘stagflationary’ environment. If the labour market is so tight that companis are forced to hike wages to meet production targets rather than getting more output from their existing workers, the Fed could feel it needs to hike rates to slow growth below the current 2% rate and keep inflation expectations from rising. This scenario is, however, less probable as the labour market could probably not sustain such a strong rate of growth with the services sector slowing.