The chart also tells us what we already know – things have been eerily calm over the last several years. We had a blip when Britain decided to leave the EU last year, and another in August of 2015. But more recently, nothing seems capable of derailing or even phasing the market. North Korea is launching missiles, the Federal Reserve is raising interest rates, and political infighting both here and abroad seems endless. But despite all this, the market hasn’t seen a down day of over 1% since October 11th of 2016!
Could this be the calm before the storm? The valuation numbers say that the next five years of market returns will probably be lower than the last five years. But if corporate earnings growth continues hold pace, we may still be a few years off from a significant correction or crash.
Stocks have posted solid gains outside the U.S. too, in both developed and emerging markets. The MSCI EAFE index, representing stocks in developed economies, and MSCI Emerging Markets index are up 5.99% and 12.14% thus far in 2017. In the last 12 months, the indexes have gained 12.14% and 16.4%, respectively.
The theme in 2016 was populist sentiment arising in Europe. Populism has to do with the interests of ordinary people. With the massive exodus from Middle Eastern countries like Syria and Afghanistan over the last few years, this idea has become a key economic influence in Europe. Across the continent, a nationalistic mentality started to spread as hundreds of thousands sought refuge in 2016. With the influx of immigrants, Europeans became less concerned about the greater European Union and more concerned about their home countries. This is one of the factors that led to Britain’s decision to leave the European Union.
One risk we discussed in prior market updates is that this sentiment will continue to spread, forcing a breakup of the European Union (EU). The theory is that if the EU broke up, significant trade barriers would arise between countries, causing economic growth to suffer.
This risk seems to have abated. The immigration issue seems to be fueling much of the populism sentiment, and the number of asylum seekers has dropped significantly in the EU thus far in 2017. At the high point, 170,000 people per month sought asylum in the EU. This number has fallen below 75,000 people per month.
With fewer people fleeing the Middle East for better lives in Europe, the populist momentum may fizzle. Leaving the EU is a somewhat radical idea, and now that immigration has tapered off it seems like populists are starting to back off the ledge. The Netherlands just held a general election on March 15th. The “Party for Freedom”, representing populism, ran on the platform of leaving the EU and halting immigration. The party led for much of the race, but ultimately lost the election handily. There are more elections and referendums later in 2017, including France in April & May and Germany in September. But at this point, the chance of a surprise vote to leave the EU is very low.
Elsewhere, China finds itself in a tight spot now that the U.S. is raising rates. The People’s Bank of China (China’s equivalent of the Federal Reserve Bank) has for years supported China’s currency, the yuan. By keeping rates higher than the U.S. and elsewhere in the world, China has encouraged capital inflows and foreign investment.
With the U.S. raising interest rates, China has pressure to follow suit. If they don’t, they risk an outflow of capital from China back to the U.S. But if they do, they risk stifling the economy with expensive borrowing costs. The government has already started to reduce spending on infrastructure, setting the country up for a potential double whammy.
Thus far, the reduction in Chinese government spending has been backfilled by an increase in private sector construction. Private construction is particularly
sensitive to interest rates, leaving the People’s Bank of China at quite the crossroad. The bank will need to navigate its positioning alongside the U.S. carefully. If it doesn’t, it’s economic growth could sputter, which would certainly cause volatility to ripple across the globe once again.
Closed-End Mutual Funds
Closed end funds are professionally managed mutual funds, but are closed to additional investment. In a traditional mutual fund, an investment manager accepts new cash from investors and issues shares of their fund in exchange. In effect, investors transact directly with the mutual fund management company. When a mutual fund closes, the manager stops accepting new cash investments. Investors are instead left to purchase shares in the secondary market from other investors.
Some closed end funds are leveraged, and borrow money for short periods of time to invest the proceeds in longer dated bonds. Normally closed end funds will borrow money at lower rates, lend at higher rates, and profit from the spread. This strategy works well when the yield curve is upward sloping and long term rates are higher than short term rates (as it is now). When the yield curve flattens, the difference between long term rates and short term rates becomes smaller. This tends to harm closed end mutual funds. Since funds typically borrow at shorter term rates, their borrowing costs increase whenever the Federal Reserve decides to raise rates.
We currently have an upward sloping yield curve, but it’s clear that as long as the economy behaves, short term rates will continue to rise. This has the potential derail returns from closed end funds. While it’s very possible longer term rates will continue to increase too (preserving spread) we’ve already seen corporate bond yields depressed, which we discussed above. Investors in closed end funds should be aware that a flatter yield curve is possible, which could drive returns on closed end funds negative.