If you’ve been thinking that stock markets have been pretty quiet this year, you are right. Through the first seven months of the year, none of three major stock market indexes has fallen by more than 5 percent. And one gauge of market movement, the CBOE Volatility Index (VIX), which measures investors’ expectation of the ups and downs of the S&P 500 Index over the next month, recently dropped to its lowest level in 24 years. Low readings have tended to be equated with low anxiety and high stock prices. Amid this environment, you might be wondering what could go wrong? There are a number of risks to the US and global markets that persist. Their existence does not mean that long-term investors should change their game plans, but they are a reminder to guard against complacency and to always approach investing with caution.
"Why are stock markets at new highs?" The easy answer is that there are more buyers than sellers. The more complicated answer is that the Dow and the S&P 500 reached new all time highs last week, as investors shrugged off post-Brexit concerns and refocused on global central banks. In the case of the Bank of England, the Bank of Japan and the European Central Bank, the bet is that each will do something in the coming months to fight economic malaise. And in the US, the recent resurgent stock market is a result of investors’ belief that that the Federal Reserve will likely sit on its hands for the remainder of the year. Even if those assumptions are correct, the climate for investors is still riddled with danger. To earn anything approaching an acceptable return, many are turning back to risk assets, despite the bump in volatility seen over the past 18 months. In fact, since May 2015, when stocks previously saw new peaks, investors have endured two corrections (drops of 10 percent from recent peak) amid worries about slowing growth in China, plunging oil prices and fears over an emerging market debt crisis.
Those who gritted it out and stayed on course with their asset allocation, have done just fine. After dropping to 52-week lows in February of this year, the Dow is up a stellar 17 percent (and up 180 percent since the March 2009 nadir). But pity the market timers who sold at the various bottom points and then chased assets higher—they are likely licking their wounds and perhaps even sitting out this most recent leg higher.
There are also many investors who are on the sidelines because they see the world as a scary place. These folks likely stumbled upon the Economist Intelligence Unit’s updated list of Top Threats as a rationale for not feeling comfortable with any risk right now. Those top ten threats are:
- China experiences a hard landing
- Currency volatility and persistent commodity prices weakness culminates in an emerging markets corporate debt crisis
- Donald Trump wins the US presidential election
- Beset by external and internal pressures, the EU begins to fracture
- "Grexit" is followed by a euro zone break-up
- The rising threat of jihadi terrorism destabilizes the global economy
- Global growth surges in 2017 as emerging markets rally
- The UK votes to leave the EU
- Chinese expansionism prompts a clash of arms in the South China Sea
- A collapse in investment in the oil sector prompts a future oil price shock
My vote for number 11 on the list is “Corporate Share Buybacks halt”. As noted in the Wall Street Journal, “Among the most prominent drivers of the 2016 stock rally has been companies’ willingness to buy back shares. The strategy…drives up share prices and improves per-share earnings by reducing the number of shares outstanding. Some investors decry buybacks as financial engineering.”
The concept of companies buying back shares to drive prices higher is what Time business and economics columnist and author Rana Foroohar calls “financialization.” In her book “Makers and Takers: The Rise of Finance and the Fall of American Business,” Faroohar says that buybacks are a type of financial engineering that can juice short-term profits, thereby enriching shareholders. Unfortunately, waving a financial magic wand over a company’s balance sheet does nothing to serve the real economy, something that would occur by a company using its capital to invest in long-term growth.
Financial shenanigans may push the stock market higher for the foreseeable future, but they are unlikely to create a sustainable economic model that will produce results over the next several years.
- DJIA: 18,516, up 2% on week, up 6.3% YTD
- S&P 500: 2161, up 1.5% on week, up 5.7% YTD
- NASDAQ: 5029, up 1.5% on week, up 0.5% YTD
- Russell 2000: 1205, up 2.4% on week, up 6.1% YTD
- 10-Year Treasury yield: 1.547%, (from 1.366% a week ago)
- British Pound/USD: $1.3214 (from $1.295)
- August Crude: $46.02, up 1.4% on week
- August Gold: at $1,327.40, down 2.3% on week
- AAA Nat'l avg. for gallon of reg. gas: $2.22 (from $2.24 wk ago, $2.77 a year ago)
THE WEEK AHEAD:
Bank of America, Hasbro, IBM, Netflix, Yahoo!
10:00 Housing Market Index
Discover, Goldman Sachs, Johnson & Johnson,, Microsoft, Philip Morris, UnitedHealth
8:30 Housing Starts
Abbott Labs, American Express, eBay, Halliburton, Intel, Mattel, Morgan Stanley
ATT, Chipotle Mexican Grill, GM, Starbucks, Visa
8:30 Philadelphia Fed Business Outlook Survey
8:30 Chicago Fed National Activity Index
9:00 FHFA House Price Index
10:00 Existing Home Sales
10:00 Leading Indicators
American Airlines, General Electric, Honeywell, Schlumberger
China hosts the G-20 meeting of finance ministers and central bankers.
It’s official: UK voters decided to leave the European Union. Brexit was a seismic and unexpected result, which caught global investors off guard (more on that later). The big question: What happens next? As noted in Brexit Q&A, the “Leave” win means that the UK government must decide when to invoke Article 50 of the Treaty of Lisbon, which outlines the legal process by which a state can withdraw from the EU. Prime Minister David Cameron announced that he would step down in October and suggested that the next Prime Minister should initiate the Article 50 process. Once it does, the withdrawal negotiations would begin. At a minimum, it would take two years, but that time frame could be extended by unanimous agreement among the remaining 27 member nations. During the process, the UK would obey EU treaties and laws, but not take part in any decision-making.
The biggest issue is how trade would be handled between the EU and the rest of the world. According to law firms Davis Polk and Sullivan and Cromwell, two powerhouses that advise multinational corporations, there are three basic options for the UK’s exit, based on existing models. Leaders of the Leave movement did not advocate a specific alternative during the campaign, so it is unclear which model they will follow.
Total exit: the UK leaves the EU and does not continue to benefit from any part of the single market. The UK either relies solely on the rules of the World Trade Organization (which include rules governing the imposition of tariffs on goods and services) as the basis for trading with the EU or negotiates a new bilateral trade deal with the EU.
The Norwegian model: the UK leaves the EU but joins the European Economic Area (EEA). The EEA is made up of 28 EU member states and three countries, which are not EU member states (Norway, Iceland and Liechtenstein), and extends the free movement of goods, services, capital and persons beyond the EU to those three countries. Under this arrangement, the UK would not benefit from or be bound by the EU’s external trade agreements. It would have to make significant financial contributions to the EU and continue to allow the free movement of persons, two of the Leave camp’s main criticisms of EU membership.
The Swiss model: the UK leaves the EU and does not join the EEA, but enters various bilateral agreements with the EU to obtain access to the internal market in specific sectors, rather than the market as a whole. Switzerland has negotiated a large number of sector-specific bilateral agreements with the EU and has access to some parts of the single market, but is excluded from the single market in some major sectors (for example, the financial services sector).
BREXIT impact on US companies: The choice of model will impact US companies that have a large presence in the UK. One sector in particular that is left hanging is financial services, because under the “Total Exit” or “Swiss” models, there would be no right for UK-authorized firms or individuals to provide financial services in the EU on a “passported” basis. This is critical because most US financial institutions currently use a UK-authorized person and/or entity to provide financial services elsewhere in the EU. Without passporting, the companies would need to obtain authorization from a EU member state by either establishing an authorized branch or subsidiary in that state.
Loss of passporting would create legal, compliance and infrastructure headaches, not to mention steep costs to US firms. Additionally, many US banks make London their hub across the pond because of the access to talent, support services and the use of English as the global language for financial services. So while many Wall Street operations and legal departments are scouting locations in Dublin and Frankfurt, they are hoping that they will not have to move the majority of their people and offices.
MARKET REACTION: At 1:00am Friday morning, when the referendum results were becoming clear, the first thing I did was to look up when US stock market circuit breakers are triggered. At that time, the British pound sterling tumbled to its lowest level since 1985, US stock futures were getting crushed and the mad dash to safe assets like US treasuries, German bunds and gold was under way. The news from trading desks across the globe was that unlike in 2008, there was no liquidity crisis and markets were functioning fairly well.
At the end of the trading day, the damage was not too bad, considering the magnitude of the news. US stock markets were down 3.5 to 4 percent, Treasury bond prices jumped and yields fell; and gold added 4.6 percent. The action in the UK and Europe was instructive: the UK FTSE 100 index fell 3.1 percent, boosted by export-driven companies that would benefit from a weak Pound. The larger FTSE 250 index fell 7.2 percent, its worst one-day drop percentage fall since Black Monday in 1987.
Meanwhile, European exchanges also slumped. The German DAX fell 6.8 percent and the French CAC-40 fell 8 percent. Investors are clearly worried about the impact of the BREXIT on the European economy and likely understand that a protracted and nasty divorce could push the EU into a recession.
CENTRAL BANK TOOLBOX: Over the past eight years, amid the financial crisis, worries about Greece and a generally sluggish economic recovery, global central banks have been able to soothe markets with interest rates cuts (sometimes going negative) and unconventional tools like bond buying (“Quantitative Easing”). This time around, though, the central bank toolbox may come under pressure. Global interest rates are already close to zero and bond buying may not do the trick if the BREXIT shock causes individuals and businesses to shut down and do nothing for a while.
That said; the next Federal Reserve occurs July 26-27 and if the cloud of EU uncertainty has prompted a further sell off in stocks, a rise in the US dollar and general mayhem around the globe, don’t be surprised if Janet Yellen and company reverse course and explicitly say that the central bank is not going to keep raising rates and would consider undoing last December’s hike and launching QE IV, if conditions worsen.
Frexit, Italeave, Czexit: Some economists and traders are concerned that because the world was not prepared for BREXIT, there could be a domino effect, whereby other nations will choose to leave the EU. Even a coordinated central bank intervention could not fight off the power that a fraying EU might create throughout the world.
And now, the weather: After talking to a number of traders, economists, bankers and analysts, it is clear to me that very few of them thought that BREXIT would occur; as a result, they are still in a bit of shock. While Friday was not terrible, the short, intermediate and long-term implications of BREXIT are simply unknowable. Like the weather in London, it looks we will be forced to live with lots of clouds, occasional storms and hopefully, a ray of sunshine.
- DJIA: 17,400, down 1.6% on week, down 0.1% YTD
- S&P 500: 2037, down 1.6% on week, down 0.3% YTD
- NASDAQ: 4708, down 1.9% on week, down 6% YTD
- Russell 2000: 1127, down 1.5% on week, down 0.7% YTD
- 10-Year Treasury yield: 1.56% (from 1.61% a week ago; touched 1.42% on Friday, just above its record low of 1.404% set in July 2012)
- British Pound/USD: $1.3649, -8% Friday, weakest level since the financial crisis
- July Crude: $47.64, down 1.6% on week
- August Gold: at $1,322.40, up 2.1% on week, a two-year high
- AAA Nat'l avg. for gallon of reg. gas: $2.31 (from $2.34 wk ago, $2.78 a year ago)
THE WEEK AHEAD:
8:30 International Trade in Goods
10:30Dallas Fed Mfg Survey
8:30 Corporate Profits
9:00 S&P Case-Shiller HPI
10:00 Consumer Confidence
8:30 Personal Income and Spending
9:30 Janet Yellen on panel at ECB central banking conference in Portugal (Panelists: BofE Gov Mark Carney, ECB Pres Mario Draghi, Brazil Central Bank Gov Alexandre Tombini)
10:00 Pending Homes Index
9:45 Chicago PMI
Motor Vehicle Sales
9:45 PMI Manufacturing Index
10:00 ISM Mfg Index
10:00 Construction Spending
The world’s largest central banks are once again dominating the chatter among traders and economists. Last week, the European Central Bank announced additional measures to simulate the moribund Eurozone; this week, the Bank of Japan will weigh potential action after its surprise decision to adopt negative interest rates in January; and the U.S. Federal Reserve will likely refrain from a rate hike at its two-day policy gab fest. The heightened central bank focus made last week a perfect time to interview Dr. Mohamed El-Erian, author of The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse. El-Erian is Chief Economic Advisor at Allianz, chair of President Obama’s Global Development Council and a LinkedIn Influencer. Between December 2007 and March 2014, he was chief executive and co-chief investment officer of global investment management firm PIMCO.
I sat down with El-Erian during a LinkedIn webcast to discuss how far the economy and markets had come since the bear market lows of March, 2009 (the S&P 500 has soared over 240 percent, including reinvested dividends), as well as the significant challenges that still lie ahead for investors and for the global financial system.
It’s not as if the Fed, the ECB and the Bank of Japan don’t get it, but just when global central banks are looking to hand off the responsibility of promoting growth, there seem to be no takers.
So where do we stand right now, seven years after we bottomed out? We have come to what El-Erian calls a “T-Junction”. As we approach the end of this recovery road, there is an equal probability that we turn left and right. On one side of the T, we remain in a stable, but slow growth world, riddled with high unemployment, increasing income inequality and political extremism. On the other side, we have politicians who wake up and get serious about creating an inclusive economy; make pro-growth structural reforms, remove debt overhangs in problem areas like student loans and get the overall architecture right. The result would be higher growth, job creation, decreasing income inequality and a drop in financial instability.
Could the stakes be any higher this political season? That’s why El-Erian says that we desperately need candidates to acknowledge the anger that the “inequality of opportunity” can breed; and then to address that anger with policies that promote inclusive growth and restore faith in the system. In other words, we need an “Economic Sputnik” moment. Perhaps that seems like a distant possibility this moment, but El-Erian remains optimistic that one can occur.
- DJIA: 17,213 up 1.2% on week, down 1.2% YTD
- S&P 500: 2022 up 1.1% on week, down 1.1% YTD
- NASDAQ: 4748 up 0.7% on week, down 5.2% YTD
- Russell 2000: 1087, up 0.5% on week, down 4.3% YTD
- 10-Year Treasury yield: 1.98% (from 1.88% a week ago)
- Apr Crude: $38.50, up 7.2% on week 7.2%, 4th straight weekly climb
- Apr Gold: $1,250.80, down 0.9% on week
- AAA Nat'l avg. for gallon of reg. gas: $1.92 (from $1.81 wk ago, $2.45 a year ago)
THE WEEK AHEAD:
Bank of Japan meets
FOMC Meeting Begins
8:30 Retail Sales
8:30 Empire State Mfg Survey
10:00 Business Inventories
10:00 Housing Market Index
8:30 Housing Starts
9:15 Industrial Production
2:00 FOMC Decision
2:00 FOMC Economic Projections
2:30 Janet Yellen Press Conference
8:30 Philadelphia Fed Business Outlook Survey
10:00 Consumer Sentiment
It doesn't get any better than spending an hour with the great economist, Dr. Mohamed El-Erian, author of the new book, "The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse". Mohamed is Chief Economic Advisor at Allianz and chair of President Obama’s Global Development Council and if that doesn't keep him busy enough, he is a columnist for Bloomberg View, a contributing editor at the Financial Times and an influencer at LinkedIn.
Mohamed started our conversation by explaining the role of central banks and how that role changed dramatically during the financial crisis, as bankers relied on a “Whatever it Takes” mentality to help rescue the economy. While he was supportive of those actions, Mohamed also recognizes that there have been serious consequences that have occurred.
During our conversation, he outlined some big problems that the global economy faces, including how to sustain inclusive growth, how to address income and wealth inequality and the yawning gap between markets and economic fundamentals.
Mohamed says that we are coming to a "T-Junction": on one end, we are destined for a low growth economy, plagued by high unemployment, increasing income inequality and political extremism. On the other end, we see a resumption of growth and broad-based job creation, with decreasing income inequality and a drop in financial instability. While we all hope for the more positive outcome, Mohamed says that there is an equal probability that either scenario plays out.
For more, you can snag a copy of his new book, "The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse".
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