The Strange Times We Live In

In many ways, the global markets are in uncharted waters with no clearly defined swim lanes. These extremes are forcing many investors to face uncomfortable questions (e.g. what discount rate should I use in my discounted cash flow analysis?) and feel pressure to compromise their valuation assumptions and discipline in order to find investible stocks.

Our predictions are no better than yours, but holding a little extra dry powder in such abnormal times provides some comfort and optionality for opportunistic buying if the future surprises to the downside. Swim carefully, my friends.

Orange charts courtesy of Bloomberg.

Global stock markets are generally at or near all-time highs:

The S&P 500 is at an all-time high:

Japan’s Nikkei 225 index has gained more than 25% over the past year to approach a 15-year high:

The FTSE 100 index is also at an all-time high:

Global bond yields are near all-time lows:

In the US, the 10-year treasury yield has drifted down from 3% in early 2014 to 2%:

Turning to Japan, we see a similar story:

In Germany, the 10-year treasury yield is at a 5+ year low:

Finally, Switzerland’s 10-year yield actually dipped into negative territory earlier this year and sits just above 0% today:

Lower rates around the world are forcing many income-seeking investors to chase yield in riskier, less familiar markets. For example, according to a recent Wall Street Journal article, junk-rated companies have raised over $20B of bonds so far in 2015, more than double the amount in the same period last year.

The knock-on effects are highly uncertain but are (at least temporarily) helping riskier firms raise financing with ease. Do European high-yield bonds really offer value? Only time will tell.

Commodities are tumbling: Bloomberg’s commodity index tracks 22 raw materials and has now declined for four straight years to sit at a 5-year low.

FX volatility is increasing: the US dollar has strengthened significantly since the summer of 2014 and sits near a 5-year low.

The chart below shows the EUR to USD exchange rate. The rate plummeted to over a 10-year low as the market digested news that the European Central Bank will introduce a $1.23 trillion stimulus plan.

Meanwhile, Japan’s yen has declined more than a third against the US dollar since Japanese Prime Minister Shinzo Abe took office in December 2012 and began implementation of monetary and fiscal stimulus. The chart below shows the impact on the yen to USD exchange rate:

Global central bank interest rate cuts and stimulus are at unprecedented levels:

Central banks around the world are playing “currency roulette.” According to Bloomberg, 19 of the 53 central banks it tracks have dropped their benchmark interest rates in the past three months – “Low rates encourage consumers to borrow and spend, increasing domestic consumption. They also devalue currencies, making exports cheaper. That’s good for the countries selling but hard on countries flooded with cheap products.”

Source: Bloomberg

In the US, the federal funds rate (below) is the interest rate at which a bank lends funds maintained at the Federal Reserve to another bank overnight. The higher the rate, the more expensive it is to borrow money. Since it is only applicable to very creditworthy institutions for extremely short-term (overnight) loans, the rate can be viewed as the base rate that determines the level of all other interest rates in the U.S. economy. As seen below, the Fed has maintained an interest rate of approximately 0% for the last five years, the lowest rate in over 50 years.

Switzerland provides a final example of the extreme interest rate levels maintained by many central banks. In January 2015, Switzerland stunned global financial markets by slashing its official interest rate to -0.75% and foregoing its attempts to cap the franc’s exchange rate against the euro. No central bank has ever set its official interest so low.

In addition to rate cuts, central banks have engaged in extreme bond-buying. The Wall Street Journal provided the following chart:

While the US ended its bond-buying program in October 2014 (it started in November 2008), the European Central Bank is just getting started. Starting in March 2015, the European Central Bank will buy $68 billion of government and corporate bonds each month at least through September 2016 (a €1tn round of quantitative easing), designed to make loans and exports cheaper so companies can hire and expand.

Japan’s most recent quantitative easing program began in April 2013 with plans to unleash a massive program worth $1.4 trillion. Under the plan, the Bank of Japan vowed to buy $70 billion of government bonds each month using electronically created money. In October 2014, with inflation worryingly low and consumer spending floundering, the Bank of Japan revealed plans to increase its buying from ¥60-70 trillion a year previously to ¥80.

The jury is still out on the effectiveness and knock-on effects of quantitative easing, but here is a 3-minute article by the Economist about quantitative easing: link. 

Global debt-to-GDP has skyrocketed:

According to a report by McKinsey, total debt worldwide (includes government, corporate, bank, and household debt) has risen by $57 trillion since the end of 2007, representing 286% of global economic output in 2014 compared to 269% in 2007. 

The Telegraph provides a longer-term ratio of global debt (measured differently than McKinsey) to GDP:

Source: The Telegraph

What now?

We have witnessed six years of mostly coordinated global monetary stimulus. What happens if / when major countries run out of monetary ammunition before global economies and inflation expectations improve? How will the exit from global stimulus play out? What happens to government debt payments if interest rates rise? Will inflation or deflation be unleashed? We do not know, but we are certainly living in interesting times that will one day make for a great case study, good or bad.