Reviewing our domestic markets for September, large-cap equities struggled with the Dow Jones Industrial Average and S&P 500 Index ending the month down 0.5% and 0.12%, respectively. Small and mid-cap securities, however, were the clear winners as the NASDAQ Composite posted a strong 1.89%.
Internationally, Asian markets slid with Japan’s Nikkei 225 Average down 0.5% and China’s Shanghai Composite off more than 2.4% for September. European equities, as measured by the MSCI Europe Index, flirted with negative territory only to notch a 0.81% gain.
Of the drivers investors honed in on during September, we believe there were three key focus areas that swayed the markets.
No Rate Increase: The Federal Reserve decided against rate increases during its September meeting but a hike before year-end appears increasingly more likely.
Black Cloud Over the Eurozone: Deutsche Bank is casting a shadow of uncertainty over not only European banking equities, but the Eurozone overall.
Currencies: The Japanese yen, defying conventional wisdom, has seen significant appreciation despite the Bank of Japan furthering its bond buying program.
Federal Reserve Standing Pat on Rate Increase
The US Federal Reserve held interest rates steady in the September Federal Open Market Committee meeting. Of the ten voting members, three voted in favor of a rate hike last month, one more than the last meeting. According to the press release, the Fed held back its increase largely due to recent tepid US economic data as evidenced by GDP growth at just 1% over the past three quarters. Officials also cut their growth forecast at the meeting for 2016 to 1.8% from 2.0% in originally estimated June. The 2017 and 2018 growth rate assumption, however, was left unchanged at 2%. Other minor changes included the projected unemployment rate of 4.8% up from 4.7% and inflation down slightly to 1.3% from 1.4% in June.
With inflation still far below the Fed’s target of 2%, the board once again signalled to a potential December hike. The Fed remains concerned that a premature rate hike could negatively impact employment and other key economic factors should economic growth continue to be sluggish.
Deutsche Bank and the Eurozone
European bank equities are down as much as 30% year to date as nervous investors panic about the possibility of a new banking crisis in the region. Given the interconnectivity of banks in today’s global market, a banking crisis in one region could easily spread to others, similar to that of a contagious virus. At the core, perhaps, is Germany’s Deutsche Bank. The low to negative yield environment in the Eurozone has significantly closed the gap between short and long term rates, squeezing the earning power of the bank. Indeed, Deutsche Bank reported a 98% decline in net income for the second quarter this year.
While Deutsche Bank struggles, the European Union’s bail out rules may exacerbate the issue should the bank require outside capital. The European Union, in cooperation with the European Central Bank, pushed for and enacted rules designed to prevent using taxpayer monies to bail out a bank. The way the rules are written, debtors, or bondholders, must first suffer losses before taxpayer funds can be considered. On its face, the fact that bondholders may suffer losses is not so egregious. However, most bondholders in Europe are not large institutions, rather they are retail investors. Unfortunately, should the European Central Bank let Deutsche Bank collapse, the German economy would likely suffer as well.
On a positive note, while a number of hedge funds are withdrawing from Deutsche, the vast majority of its more than 200 derivatives-clearing clients have made no changes. Deutsche Bank has weathered a number of crises and was able to survive, albeit walking away with a few scars. While Deutsche Bank could emerge from its current situation, the rising level of nonperforming loans among southern Europe’s banks have investors just as jittery. We would be remiss if we didn’t mention that Spain, Portugal and Italy have nonperforming loans worth over 540 billion euros ($600 billion). In Italy alone, it exceeds 360 billion euros ($400 billion) and amounts to nearly 18% of all bank loans in the county. We have been aware of the current state of the European banks and continue to watch the situation closely.
Systematic Risk among Global Systematically Important Banks:
Currencies
The yen has begun to appreciate – and rapidly. As of the end of September, the Japanese currency was up 15% against the US Dollar, 11% against the Australian Dollar, 13% each against Swiss Franc and British Pound and a whopping 26% up against the Euro. Indeed, the yen is at the highest level against the dollar since 2014. Generally, currencies tend to appreciate when exports or the interest rates are rising. However, none of those catalysts have taken place over the recent past. The Japanese currency is traditionally considered a safe haven in turbulent times, and while Bank of Japan announced more easing, turning conventional wisdom on its head. Central banks typically turn to easing, or bond buying, to artificially depress interest rates, spark spending and depreciate their native currency. In times of turmoil when countries are struggling with significant debt burdens, Japan is a net international investment surplus country. Japanese investors own more foreign assets than foreign investors own of Japanese assets.
Source: Data from investing.com, modified by Cresco.
This large net foreign asset position, combined with Japan’s large current account surplus, make it the world’s number one creditor nation. During periods of risk aversion, cash inflows caused by repatriations back into Japan are part of the reason why the yen appreciates. Japanese investors reduce their foreign asset exposure, bringing those monies back into Japan. The effect of converting foreign currency into Japanese yen increases the demand for and raises the value of the currency. Conversely, the value of the US dollar is largely being driven by the prospect of the US Federal Reserve raising interest rates as investors examine rate differentials between sovereign government bonds.
Concluding Thoughts
It is important to remember that there will always be a certain degree of uncertainty in the markets. The issues we explored above represent a small subset of economic, geopolitical and economic events that investors are focusing on. However, we maintain that an active approach will give investors the ability to remain flexible as we enter the final stretch of 2016 and believe that all would benefit from working with an advisor to develop a comprehensive financial plan.
This newsletter was written and prepared by CWM, LLC. Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
DJIA
The Dow Jones Industrial Average is comprised of 30 stocks that are major factors in their industries and widely held by individuals and institutional investors.
NASDAQ COMPOSITE
The NASDAQ Composite Index measures all NASDAQ domestic and non-U.S. based common stocks listed on The NASDAQ Stock Market. The market value, the last sale price multiplied by total shares outstanding, is calculated throughout the trading day, and is related to the total value of the Index.
S&P 500 INDEX
The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
NIKKEI 225 AVERAGE INDEX
The Nikkei 225 Average Index is a Japanese index that tracks the top 225 companies listed on the Tokyo Stock Exchange. It includes the most liquid Japanese stocks listed in the first section of the Tokyo Stock Exchange. It is price-weighted and yen-denominated.
MSCI EUROPE INDEX
The MSCI Europe Index captures large- and mid-cap companies across 15 developed markets countries in Europe
SHANGHAI COMPOSITE INDEX
The Shanghai Composite Index is a market index of all stocks (A shares and B shares) that are traded on the Shanghai Stock Exchange. It tracks the largest publicly traded companies in China.
Links Used:
Bloomberg, June 2016. http://www.bloomberg.com/news/articles/2016-06-20/mr-yen-sees-currency-rising-toward-100-per-dollar-by-year-end
Shadforth Financial Group, August 2016. http://www.sfg.com.au/blog_posts/shadforth_blog/sfg/the-japanese-yen-why-is-it-a-safe-haven
Bloomberg, August 2016. http://www.bloomberg.com/news/articles/2016-08-18/yen-jumps-past-100-per-dollar-for-third-time-since-brexit-chart
http://www.businessinsider.com.au/chart-recent-history-says-the-japanese-yen-tends-to-strengthen-following-a-boj-policy-meeting-2016-9
Business Insider Australia, September 2016. http://www.businessinsider.in/ALBERT-EDWARDS-A-Tidal-Wave-Of-Deflation-Is-Coming/articleshow/45141296.cms
LPL Research, April 2016. https://lplresearch.com/2016/04/08/is-yen-reversal-a-concern/
Equities, April 2016. https://www.equities.com/news/yen-volatility-puts-market-on-precipice-of-crash
Welker’s Wikinomics, November 2008. http://welkerswikinomics.com/blog/2008/11/05/up-up-and-away-why-are-the-dollar-and-the-yen-on-the-rise-2/
Wall Street Journal, April 2016. http://www.wsj.com/articles/with-japans-yen-still-rising-ceiling-appears-political-1460118642
Pound Sterling Forecast, October 2016. http://www.poundsterlingforecast.com/category/sterling-weakness/
http://news.ikutseo.com/news/Fed-stands-pat-on-rates,-signals-December-hike/
Ikut SEO News, 2016. http://news.ikutseo.com/news/The-Origins-of-‘Standing-Pat’/
Bloomberg, September 2016. https://www.bloomberg.com/view/articles/2016-09-21/five-charts-show-why-the-fed-shouldn-t-raise-interest-rates
The Fiscal Times, June 2016. http://www.thefiscaltimes.com/Columns/2016/06/14/Fed-Should-Wait-Clarity-Raising-Rates
Fortune, September 2016. http://fortune.com/2016/09/27/deutsche-bank/
Investopedia, September 2016. http://www.investopedia.com/news/deutsche-banks-fine-and-its-systemic-effects-db/