2016 has been a tumultuous ride for stocks thus far. The S&P 500 started the year down over 10% through the first six weeks of the year, as persistently low oil prices and concerns about China’s sputtering economy struck fear throughout the markets. Since then, strong economic data in the U.S. has helped stage an impressive comeback, and to date the index has rebounded right back to where it opened the year.
Normally I like to use Investment Insights to share my take on various sectors of the world’s capital markets. Specifically I try to highlight areas that might help investors in their decision making. This quarter will be no different. I’d like to start by reviewing some recent U.S. economic data, but devote the majority of this quarter’s publication to a topic that hasn’t garnered as much attention in the media recently: foreign exchange rates.
The labor market is the shining star in the U.S. economy right now. The unemployment rate is currently 4.9%, and while many analysts use the criticism that this metric doesn’t account for people who’ve given up looking for work, the labor force participation rate is rising again. If there is any cold water to be thrown on recent employment data, it’s from wage levels. Wages across the U.S. fell 0.1% in February, which is disappointing after increasing 0.5% in January. Keep in mind that any increase in wages is always reduced in real terms by inflation. After accounting for inflation figures, wages in real terms were down in both months.
The Federal Reserve did not raise rates at its most recent meeting last week. Their monetary policy is decidedly becoming more restrictive, but the governors are in no hurry to raise rates faster than is necessary. While the bank will do anything within its power to keep inflation under control, it still wants to be as accommodative as possible to allow the economy room to grow.
At this point, inflation numbers are trending up slightly over 2015 data. January and February saw annualized price increases of 1.4% and 1.0%, respectively. The 2015 inflation figures were quite low, in part because they were suppressed by muted energy prices. With oil prices creeping upward again inflation numbers are inching back up to the Fed’s target range of around 2% per year.
The majority of governors in the most recent Fed meeting now believe that there will be fewer rate hikes in 2016 than previously forecast last December. The group predicts a slow inflationary trend in the energy sector, and thinks that will ease some of the pressure to raise rates later this year. Most governors are predicting two rate hikes between now and the end of 2016.
Remember the term quantitative easing? This was the Federal Reserve’s regime of suppressing interest rates and stoking the economy by buying up assets and injecting dollars into the banking system. In reference to the economic cycle, the years the Fed spent employing quantitative easing (QE) marked the peak of some of the most accommodative monetary policy we’ve ever seen. The end of QE in the third quarter of 2014 marked a change in direction, from a highly accommodative policy toward a more restrictive policy. The Fed has raised short term rates once since lifting QE, and has plans to make further hikes later this year.
Even though we may be at a more restrictive point now than we were 18 months ago, we are still in a highly accommodative phase of the cycle. As the economy picks up steam, and as inflation creeps back into the picture, the Fed will continue to tighten the reins and become more restrictive. Inevitably the economy will slow to a recession at some point (hopefully years down the road), at which point the Fed will start easing again and become more accommodative. So goes the economic cycle.
When we compare our phase within the economic cycle to other countries around the world, we are slightly ahead of the pack. While we are becoming more restrictive and raising rates, other central banks around the world are still easing.
The European Central Bank two weeks ago announced that they would expand asset purchases beginning in April of this year. The bank’s new monthly quota will be $87 billion worth of securities, and it will now be allowed to purchase corporate backed debt in addition to government issues.
In early March China’s central bank, the People’s Bank of China, introduced further monetary stimulus by lowering their bank’s reserve requirements. This allows banks to lend more money against their deposits. The move stimulates lending and injects more currency into circulation – another maneuver meant to stimulate their economy.
The Bank of Japan has undergone massive stimulus efforts over the past decade, and was the pioneer of QE. The bank continues to explore an expansion of its asset buying regime.
The common thread here is that many countries around the world are still easing their monetary while we are tightening. Central banks in these countries are artificially depressing interest rates, while in the U.S. rates are on the uptrend.
The reason investors should pay attention to this dynamic is that currency tends to flow into countries with higher interest rates. Anyone seeking income today might consider buying treasury securities issued by some of the more stable governments around the world. And when comparing the U.S., a stable country in Europe like Germany, and Japan, the yields on their 10 year notes are currently 1.89%, 0.18%, and -0.09%, respectively.
Practical investors will opt for the highest interest rate of 1.89% in the U.S. This means that international investors would need exchange their home currencies for U.S. dollars, there will be more demand for the dollar, and it will tend to appreciate. There are many other factors that affect exchange rates too, but in general as interest rates rise that country’s currency tends to appreciate.
This is exactly what we’ve seen since the U.S. since the end of QE. The image here is a graph of the U.S. dollar index. This index measures the strength of the dollar against a basket of other currencies, and is a good representation of the relative strength of our currency.
Unsurprisingly, the dramatic rise coincides with the beginning of the Fed’s transition into more restrictive policy. QE ends, interest rates rise, and the U.S. dollar appreciates.
A strengthening currency has several implications for consumers, businesses, the economy, and the markets. From the consumer’s perspective, nothing could be better than a strengthening U.S. dollar. Goods imported from foreign countries become cheaper, meaning that the luxury $60,000 sedan becomes a bit more affordable. This isn’t just true of imported goods either. A stronger dollar means the cost of international travel falls for U.S. citizens.
For businesses, appreciating currencies can be a headwind. Businesses operating exclusively within the U.S. might be unaffected (unless they import goods from abroad), but those operating internationally will likely see a slowdown in demand. A stronger dollar means that any goods sold in U.S. dollars become more expensive to foreigners.
From a macro standpoint, appreciating currencies can have offsetting effects. First, the fact that a currency is simply appreciating generally means that the economy is on good footing. But also, since imported goods become less expensive consumers tend to have more disposable income. Over time, the extra pocket change gets injected back into the economy. The downside for the economy is the same as individual businesses: exports become more expensive to foreigners.
U.S. stocks have rebounded in the second half of the first quarter just as aggressively as they fell in the first half. The S&P 500 is now right back to where it opened the year, at 2038.
This price level works out to a P/E ratio of 23.53 based on the index’s last 12 months of earnings. This metric is on the higher end of the spectrum, given a P/E ratio of 20.52 one year ago and a long term average of around 16. P/E ratios tend to fluctuate around their long term averages over time, meaning that stocks may not have much more room to run without significant boosts in earnings.
Beyond valuation, an appreciating dollar is another headwind for domestic equities. Beyond the fact that exports become more expensive, companies doing business overseas are penalized when “repatriating” their cash.
Consider a computer manufacturer, which sells microchips out of an office in Europe. The company sells its goods in exchange for Euros. The company’s earnings in U.S. dollar terms will be depressed as the dollar appreciates against the Euro.
Additionally, there are many large companies today that maintain foreign operations and deliberately choose not to bring cash back to the U.S. for tax reasons. Apple is a good example here, as they are notorious for parking cash overseas in order to avoid U.S. taxes. Other large cap stocks like Pfizer have even purchased entire companies in “tax inversion” strategies. In this move, a domestic company aims to relocate their headquarters overseas to avoid U.S. corporate taxes.
Today, over 40% of earnings produced by S&P 500 companies comes from international operations. And as the dollar continues to appreciate, there will be growing pressure on these companies to keep cash overseas in order to preserve their bottom lines. Whatever their decision, this will continue to be a headwind for large cap stocks.
Emerging Markets Stocks
Historically, a strengthening U.S. dollar might spell trouble for the emerging markets. The vast majority of companies in the emerging markets in the past have financed their operations by borrowing U.S. dollars. In doing so, foreign businesses could tap into the vast market of investors who might otherwise be scared off by investing a volatile foreign currency.
The problem for borrowers in the emerging markets was that any appreciation in the U.S. dollar meant that their debt service became more expensive. For example, a growing company in India might issue debt in U.S. dollar terms in order to access a large pool of institutional investors. The company does business in its home currency of rupees. Every six months when interest is due, it must convert its rupees into dollars in order to service the debt. Then at some point later on, the company will pay back the principal amount it borrowed.
When the U.S. dollar appreciates, it makes the interest and principal payments more expensive to the borrower. And from the investor’s point of view, this makes investing in both the company’s equity and debt a far riskier proposition. Bigger interest payments hurt the company’s bottom line, crimping equity returns and increasing the likelihood they’ll default on debt issues.
Times are changing though, and this is not as true today. The International Monetary Fund (IMF) reports that most emerging market countries now borrow in their own currencies as opposed to the U.S. dollar. So, default risk in the emerging markets is lower today as a result. Yes, U.S. investors are still subject to the exchange rate risk of their investment. But, no longer is this explicitly tied to the likelihood that a borrower repays their loan.
As it stands today, several analysts are proclaiming that emerging markets are the “trade of a decade.” The asset class has seen fairly low returns over the last ten years, and significant pressure in the last three. Today, emerging market stocks are the most reasonably priced asset class around. The Shiller P/E ratio, which compares prices to the asset’s average earnings over the last 15 years and is an improvement on the traditional P/E ratio, is currently 10. This is well below its long term median of 18. In comparison, U.S. stocks have a Shiller P/E ratio of 24 vs. a long term median of 16. International stocks in developed economies are also on the low end of the valuation spectrum. The asset class currently has a Schiller P/E of 13, compared to its long run average of 22.
We shouldn’t make investment decisions based on valuations alone though. In the emerging economies today political and economic stability vary greatly by region, and persistently low oil prices affect each emerging economy differently. Venezuela is currently undergoing a political revolution and fighting off hyperinflation. Other countries like Russia rely heavily on oil exports, meaning their economies will likely struggle until we see a stronger rebound.
Today the bulk of emerging economies are actually oil importers, and aided by lower prices. For investors with a long exposure to oil, the emerging markets can add a valuable diversification benefit to their portfolio. In any case, investors should consider adding exposure to international equities in both developed and emerging economies.
The rebound in stocks has translated to risk taking behavior in other asset classes as well. There’s been an influx of cash flowing into high yield corporate bonds, which both boosts market prices and depresses current yields.
Income investors should consider investment grade corporate bonds. The volatility in high grade corporate bonds is about half that of stocks, and average yields for longer dated maturities is hovering around 5% per year. For those willing to accept additional credit risk, lower rated investment grade corporate bonds currently yield up to 7%. When compared to less than a 2% yield from 10 year treasury securities, the sector is very compelling.
This doesn’t mean the asset class is free of risk. Investors must weigh both interest rate risk and credit risk. If economic data continues to improve, a rate hike in June is likely. Plus, more corporate bond issues are being downgraded recently than upgraded. Standard and Poor’s has even reported that average bond ratings haven’t been this low for 15 years. While this speaks to the credit strength (or weakness) of the asset class, there are many high quality individual bonds to choose from, and many funds available that buy only high quality bonds.
Individual investors must always keep in mind that investing in corporate bonds can come with significant transaction costs. Individuals are stuck paying a much higher spread between bid and ask prices than institutions, and these spreads can vary widely between brokerage firms. Fortunately, the Financial Industry Regulatory Authority recently passed a rule requiring brokerage firms to disclose their markups on bond trades. The rule must still be approved by the SEC, but if passed it will help shed light on trading costs.
Until then, the majority of investors are most likely better off investing in funds when it comes to corporate debt. There are trading costs and annual expenses when investing in funds too, of course. But even so, unless you are trading in large sizes and very infrequently, funds are more diversified and less expensive to the average investor.