So there we are; 2016 is all but done and dusted and it has, to be frank, not been a great year.
Skiers know that, when you change direction, at some point you will be pointing straight down hill. If confident, the turn is easy and it is those who are fearful of the turn who tend to get stuck half way through it and who end up careering out of control over the precipice. What has been lacking above all in markets in 2016 has been the confidence that the turn from the loose money policies pursued by central banks for the best part of a decade to a more normal interest rate structure can be negotiated without the world as we know it coming to an end.
Before I go any further, I’d just like to add that no, I don’t think 2017 is going to be the year in which equilibrium between monetary policy and asset prices is found. I also don’t expect the relative returns between bonds and equities to be re-established as historically low coupon and dividend yields continue to expose investors to a clear and present risk of negative total returns. In 2016 the risk/reward measure has generally favoured equities, which are either denominated in US dollars or which include a considerable portion of dollar-denominated earnings. Making money in 2016 has in most cases, if we’re really honest, been more a matter of luck than of judgement and as long as central banks persist in manipulating the cost of both money and financial assets that will not change. What we are experiencing is the gradual withdrawal by the Federal Reserve from its role as puller of all strings and in doing so it handing pricing power back to organic demand and supply. Is it therefore surprising that investors’ money is racing into the US where good economic discipline and sound analysis are rewarded more highly than blindly sucking on the teat of the ECB, the BoJ or the PBoC?
That said, the two-year note now yields around 1.25%. A 50bp back-up in the yield to 1.75% would cost around 1 point on the price, thus still leaving a small but still positive total return. Even at over 2.5% yield, it would only take a back-up of 30bp to push a 10-year Treasury into negative total return territory and for the long bond it would need a yield increase of 20bp to cause the same effect.
The final removal of “extraordinary measures” from US monetary policy will of course also bring some serious changes to the new normal and a new-new normal might be called for. As share prices rise along with the cost of money, the economics of the leveraged buyout game will surely change. In the same way, the corporate treasurers’ arbitrage of borrowing cheaply for the purpose of buying back shares will lose its attraction. Most major corporations have been preparing and are sitting on a sea of cheap cash which they have been accumulating over the past few years. In order to fund, should they need to, they will surely be tempted to re-release stock from treasury effecting the reversal of price support provided by share buybacks.
Lofty
We go into the end of the year with stock markets at lofty levels. Really old troopers will recall the Nikkei hitting its all-time high of just under 39,000 points in the last days of trading in 1989 when there were still 4,716 reasons why the market could never go down again. There followed a 13-year bear market which took the index down to 7,752 points in April 2003. I’m not suggesting that the Dow will touch 20,000 points and then fall back to 3,500 points over the decade but it should not be forgotten that share prices are, at the end of the day, a function of discounted future cash flows and that if the discount factor rises, the value of those cash flows declines.
Investors and traders should be braced for another year of hiatus and volatility; saving the patient might require the amputation of the odd limb or two. After thirty years in markets, I’m afraid that I will have to take the coward’s option and hide behind the Socratic paradox by declaring that I know that I know nothing.
Last night’s news that Japan has once again overtaken China as the largest holder of US Treasuries, albeit just by a whisker, ought not surprise. China is busily trying to prop up the yuan while Japan seems happy to let the yen decline. Since June 2015 China has been selling reserves which have declined by about a quarter from US$4trn to just about US$3trn. These are capital flows of monumental proportion and only fools would try to stand in their way.
One of the key points to carry into 2017 is that fiat currencies remain on the critical list and that a crisis of confidence, not in the commercial banks but in the central banks, has to be very close to the top of the list of market risks for the coming year. The big equity rally that has pushed most indices to levels which a few months ago would have been unthinkable will leave a warm and fuzzy feeling – such a shame that bonuses will already have been set – but most of the underlying issues which turned them into a minefield for 10 of this year’s 12 months have not gone away. The Trump presidency, the cause of the big rally, doesn’t even begin until five weeks from today. Let’s wait and see what follows when the rubber finally hits the road.
After all the decades during which I’ve been practicing this sport of ours, I’ve learnt that whatever year one happens to be in, last year was always so much easier to make money in. My last and sole prediction for 2017 is that, a few weeks in, that is what everyone will be crying…
Alas, it is that time of the year again and all that remains is for me to wish you and yours a very merry Christmas and a happy and prosperous New Year. At this point I would like to thank all those who have helped to make the continued publication of my thoughts and impressions possible. Firstly, I’d like to thank Sol Group for offering me an unencumbered platform from which I can observe and comment on the events and the people who make markets move. I should also like to thank the editor and the staff of the International Financing Review for keeping my window to the world open. It is now a full year since I hung up my phones and retreated from the front line of trading in the City to the rural idyll of the Oxfordshire Cotswolds. Hence my special appreciation goes to those friends who still talk to me although I bring no business and who keep me abreast of the day to day goings on in Moneytown.
Finally, my very best wishes go to those among us who have suffered severe challenges this year, especially to my fellow scribblers Bill Blain of Mint Partners and Russell Taylor of the Alex cartoon who have both faced significant health issues and who are both making astonishing recoveries but above all to the families of those who, at the end of this year, are no longer with us.