In 2013, the financial markets began to put the fears rooted in the Financial Crisis behind them as investors began to sense that there was light at the end of the tunnel. Optimism seemed to replace fear and investors began a flight out of the safety of bonds and into equities. As last year drew to a close, eyes and ears began to focus on what 2014 would bring for the markets. Without question, the biggest topic of debate is about the direction of interest rates this year and their impact on the financial markets. From our perspective, the interest rate debate can be broken down to a ‘’glass half full or half empty’’ argument. The optimistic perspective is rooted in the belief that interest rates are only returning to a more normal level due to the fact that the global economy is getting stronger. The gloomy argument is that the economic recovery is not strong enough to withstand higher interest rates and it could be cut short just as things were getting back to normal.
Interest Rates: A new normal?
Conventional wisdom coming out of the financial crisis was that the dominance of the US economy would gradually wane as the US was akin to a wounded giant with far too many problems. In addition, it was thought that super charged economic growth rates of China, India and Brazil would shift the fulcrum of the global economic balance away from the US. Over 5 years later, it would be safe to say that the decline in US economic relevance was greatly exaggerated. The US economy is showing the strongest growth rate amongst the G7 group of countries and as the largest economy in the world, the US is a key part of reigniting global economic growth.
As economic conditions have stabilized, the US Federal Reserve has begun to take the first tentative steps towards normalizing US interest rates by decreasing its monthly bond purchases from $85 billion to $65 billion. Since these bond purchases (known as quantitative easing) were aimed at keeping interest rates low, the markets have interpreted this as the first step towards a tightening of monetary policy. The bond market has wasted little time in pushing interest rates upwards. In fact, between May and December of last year, interest rates rose at the fastest pace in nearly 50 years. This has many observers wondering if the three decade trend of falling interest rates has come to an end and whether there will be a long term trend shift towards rising interest rates.
Emerging Markets Fall
Historically, the emerging markets have felt firsthand the effect of a backup in US bond yields. It used to be said that whenever the US bond market sneezes, the emerging markets get the flu. Amazingly, despite the enormous wealth created in those nations over the last decade, it seems that they are still at the mercy of the US bond market and interest rates. We are amazed because no matter how much things change, they still remain the same for the emerging markets.
As interest rates in the US have risen, the weakness of emerging markets nations has been exposed. Chief amongst them is the fact that they have been borrowing and spending more than they ought to have while their imports have been rising too quickly. The imports are being fuelled by easy money policies that are aimed at continuing the economic recovery. As the US makes a switch towards a slightly less accommodative monetary policy and its interest rates rise, international capital flows have been coming to the US – leaving the US dollar stronger and the currencies of the emerging markets nations weaker (see chart below).
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These nations cannot afford a weaker currency because it tends to fuel inflation in their economies by making their imports stronger. The only cure for inflation and the discouraging of the capital exodus is to raise interest rates. But here is where it gets challenging for them: if they raise interest rates, their economic growth rates will weaken and capital outflows will only increase once again. So begins a vicious circle as selling begets more selling. Some emerging markets countries have tried to shock their currencies higher by raising interest rates by 3-5% in one fell swoop. So far, markets have calmed down but the consensus is that this is not enough as investors believe that ultimately these countries will have to walk away from higher interest rate policies. They believe that they will buckle under the pressure of trying to maintain economic growth rather than price or currency stability.
A textbook illustration of this scenario is playing out in India. A falling currency and rising inflation have left India’s central bank between a rock and a hard place as it must choose between stopping inflation with even more vigor (raising interest rates again) and holding economic growth back still more. India’s central bank has gone so far as to call for central bank decision making to be more coordinated globally. While this is easier said than done and perhaps not even feasible given that the economic constraints of nations vary so widely, it is a recognition that the US footprint is cast far and wide and ultimately the decisions of the US central bank have implications for the international community. The Fed has been unusually blunt in responding to critics who blame US monetary tightening for the problems of the emerging economies. Jeffrey Lacker, a Federal Reserve governor was recently quoted as saying that its policies are conducted strictly towards its mandate of “price stability and maximum employment here in the United States.”
China is also suffering from the after effects of its ultra-easy monetary policies that was implemented to combat the effects of the financial crisis in 2008. China’s monetary stimulus far exceeded the one undertaken by the US even though its economy was less than half the size of the US economy. Chinese policy makers have come to grips with the fact that they have lost control of their economic levers and have begun to crack down with vigor on lending activity within the Chinese economy. Several times in the last three months, Chinese banks have found a severe lack of liquidity and overnight interest rates ended up spiking to nearly 9 percent as the Chinese central bank sought to send a message to the banking industry that it was serious in its attempts to cool lending activity.
One of the great debates in the financial markets is whether or not China will suffer a hard landing or a gentle slowdown. As we have highlighted in past commentaries, China’s problems are rooted in too much lending that is fueling an excess in the construction of housing and factory capacity. According to data from the International Monetary Fund, China is only using about 60% of its industrial capacity even though the economy is growing at over 7 percent annually according to the latest government data. The challenge of Chinese policy makers is to ensure that they are able to engineer a slowdown that does not turn into something more severe.
Latin America: Getting Squeezed
Perhaps no country has suffered as great a decline in investor enthusiasm as Brazil. It has gone from a nation that was able to borrow money at interest rates lower than the US in 2007 to one that has now raised rates to 10% in order to contain inflation (which is approaching 6.3%) and support its currency which is down nearly 20% since May of last year (coinciding with the first rumblings from the Fed that tapering would begin).
North America: Recovery in Place
North America seems to be an island of relative tranquility. US economic growth has begun to show some stickiness as the construction industry has continued to flex its recently thawed out muscles and car sales continue to be strong. Of these two important pillars of the US economy, car sales are worth watching at this point with a small level of caution. Unsold car inventories sit at about $100 billion currently and that amounts to about three to four months of demand – whereas 60 days of sales in inventory is considered healthy. Going forward, it should be a buyer’s market for cars. Real estate continues to show a healthy decline in inventory and this should fuel future demand as the US housing stock is rebuilt.
US housing is especially important for Canada as its lumber industry has begun to benefit from the impact of the rebound in home construction. Lumber prices are strong and the Canadian dollar has declined – making Canadian exports cheaper. This is sorely needed for the Canadian economy as manufacturing in Canada has been very slow to recover since the last recession. Throw in a moderation of commodity prices and a reduced US appetite for oil and gas from Canada and we can see why Canada’s economy needs a little help.
That help has come in the form of a lower dollar but more is needed. Canadian consumers have moderated the rate of increase in their debt levels and are heeding the warnings from the Bank of Canada and the Canadian government that leverage needs to be reduced. A great deal of the debt predicament has to do with Canadian mortgage debt. Canada has received not so favorable comments from international bodies such as the IMF and OECD about the overvaluation of Canadian real estate. So far, those comments have had little impact. Part of this is due to the fact that interest rates continue to remain low and we have recently seen additional declines in mortgage rates this year.
The weak Canadian economy has left the Bank of Canada with no choice but to become a little more vocal in its stance that interest rates in Canada could remain lower for longer. This policy change and a weak commodity backdrop has pressured the Canadian dollar lower. From its highs of Q3 2011, the Canadian dollar is down almost 16%.
Emerging markets have now declined to valuation levels that have made them cheap relative to most developed markets. From these levels, emerging markets have historically gone on to outperform the developed markets. While we are attuned to the valuations in this part of the world, we continue to weigh the potential of further declines and have highlighted our stance in our most recent Strategy Notes publication. (Please contact us for a copy of this publication).
Once again, we find ourselves looking at equity markets as being at best fairly valued as a whole but continue to find good companies trading at cheap valuations from a bottom up, standalone basis. We believe that at this point, investors should remain selective towards opportunities in the equity markets. As our title to this newsletter suggests, investors had likely become too enamored with equities and were beginning to throw money at the equity markets for fear of being left behind.
Interest rate anxiety is the best way to describe the behavior of the capital markets thus far in 2014. History shows there is always an adjustment period as interest rates begin to normalize and this time is no different. But capital markets tend to have a resilience and a capacity to look through the fog and chart a course that is often questioned through the lens of fear induced volatility.
Pacifica PartnersCapital Management Inc.
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