Daily Commentary

Providing succinct, entertaining and savvy thinking on global capital markets. Our goal is to provide discerning investors the most essential information and commentary to stay in tune with what's happening in the markets, while providing unique perspectives on essential financial issues. And just as important, Fisher Investments MarketMinder aims to help investors discern between useful information and potentially misleading hype.

The Bank of Japan Keeps Swimming Upstream

Central banks worldwide are raising interest rates fast and furious, with even the Swiss National Bank getting in on the action. Yet there is one major outlier: Japan, where the Bank of Japan (BoJ) remains wedded to negative interest rates and its yield-curve control (YCC) program even as the weak yen creates big headaches for businesses and politicians alike. Meanwhile, Japan isn’t really playing its traditional defensive role during global stocks’ bear market, and we think the BoJ’s misadventures go a long way toward explaining why. Let us discuss.

The BoJ implemented YCC—which sets targets for 10-year Japanese Government Bond (JGB) yields—in September 2016. Then, the BoJ targeted a 0% 10-year yield, though most thought officials allowed fluctuations within a bandwidth of +/- 0.1 percentage point (10 basis points, or bps). The BoJ pursued this strategy in part because Japanese banks complained the BoJ’s quantitative easing (QE) and negative policy rate—which pulled 10-year yields below zero—made it all but impossible to lend profitably. At the time, we called the BoJ’s policy update a “stealth taper” since it required the bank to let 10-year yields rise, implying fewer bond purchases. Since its implementation, the BoJ has widened its target trading bandwidth twice: in July 2018 (up to +/- 20 bps) and March 2021 (up to +/- 25 bps).

This target is effectively an interest rate peg, which is inherently unstable. Pegs work as long as the targeted rate isn’t far off what the market-driven rate would be. Once markets start moving, though, it takes extraordinary intervention to preserve the fixed value—and that is happening now. As bond yields globally climbed this year, 10-year JGB yields followed, reaching the BoJ’s 0.25% ceiling. Market forces have tried to push Japanese yields even higher, prompting the BoJ to announce in late March that it would buy an unlimited amount of 10-year JGBs to keep yields at or below 0.25%. Without that extraordinary intervention, 10-year JGB yields would likely be far higher than where they are today.

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Some Key Concepts Useful in Navigating Today’s Markets

Since stocks breached -20% on June 13  from their prior high, crossing the popular threshold for a bear market, a constant drumbeat of headlines has warned of worse to come. In these trying times, the urge to do something may seem overwhelming—but doing something can easily backfire. In that vein, here are some dos and don’ts we think can help you in difficult times like the present.

We know bear markets are hard—and frightening. Enduring one is far from ideal. When a bear market comes amid a series of seemingly relentless negative news stories, cutting equity exposure may look like the sensible and prudent thing to do. Take your losses and live to fight another day. In our experience, though, that isn’t wise, as selling crystalizes declines into losses and increases the chances you miss the recovery—the chance to recoup those declines. Hence, our first recommendation.

Don’t panic. When all seems lost, that is the best time to stay calm and collect yourself. First, assess your situation. Ask: Is my portfolio’s asset allocation (the mix of stocks, bonds, cash and other securities) designed with bear markets in mind? Meaning, are the expected long-term returns it is based on inclusive of bear markets? If so, it should meet your longer-range financial goals even with occasional downturns—including historically bad ones. Mitigating bear markets’ drops may be nice, even beneficial, but it isn’t necessary to reach your goals. The ride may be bumpy, but participating in a bear market shouldn’t derail your long-term goals as long as you also participate in bull markets.

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On Wednesday’s Dreary British and Canadian Inflation Data

The Anglosphere got another inflation sucker-punch today, this time courtesy of May data from Canada and the UK. Unsurprisingly, inflation worsened in both nations, with consumer price index (CPI) inflation speeding to 7.7% y/y in the Great White North and 9.1% y/y in Britain.[i] And unsurprisingly, coverage was quite dour. That is understandable, considering inflation makes life difficult for many. It has also become a thorny political issue, so please understand that we are addressing this from an investing perspective only and don’t intend any political statements. To that end, while we don’t think either report yields any great insight from a data analysis standpoint, we find the reactions rather illuminating on sentiment, as they show how far expectations have deteriorated. We hesitate to call it capitulation, but it does indicate it shouldn’t take much for reality to surprise positively later this year, which could help bring stocks some relief.

In both places, coverage fixated on central bankers’ alleged failure to act against rising prices sooner and forecasts for inflation to get even worse before it gets better. There was a lot of finger-pointing from politicians, not to mention a chorus of calls for the Bank of Canada and Bank of England (BoE) to do more to tackle the problem. Yet pundits also bemoaned that the rate hikes they view as necessary to beat inflation also risked “possibly” inducing recession, echoing Fed head Jerome Powell’s comments to Congress today.[ii] Rock, meet hard place.

Forecasts for worse to come stem largely from the knowledge that oil and gas prices continued rising in June, with food and metals prices also jumping. The weaker Canadian dollar and British pound also fanned fears, as they raise import costs. That got the blame for Canadian services prices rising 5.2% y/y, which seems rather suspect considering US services inflation is even faster at 5.7% y/y in May and the dollar has soared this year.[iii] In our view, a better explanation is that services prices are under a trio of pressures from reopening-fueled demand, supply costs and labor shortages, creating a classic supply/demand mismatch. We think it is a global pandemic-driven dislocation that, while frustrating, is likely to ease as economies gradually return to pre-lockdown trends. But if a hyper-focus on weak currencies creates much more dismal expectations, then so much the better for stocks. Surprise power will be that much easier to attain.

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France’s Parliamentary Elections Deliver Divides

Editors’ Note: MarketMinder favors no politician nor any party. We assess political developments for their potential economic and market impact only.

France’s legislative elections delivered a major shift Sunday, but not the one political analysts expected. Entering the weekend’s second-round vote, most anticipated President Emmanuel Macron’s Together! movement would lose its majority, and they did. But the biggest beneficiary of Macron’s collapse wasn’t the leftist alliance known as Nupes (short for New Popular Union), which won the second-most seats but badly underperformed polling projections. Rather, Marine Le Pen’s National Rally—a nationalist party with a leftist economic platform—surprised observers by jumping from 8 seats to 89.[i] Le Pen’s ascendance as the second-largest single party in the National Assembly has hogged headlines since, with most observers seeing chaos and deadlock dooming Macron’s reform agenda. In our view, people are merely putting a colorful, hyperbolic spin on traditional gridlock, which stocks should be just fine with once the uncertainty weighing on stocks globally starts clearing.

It takes 289 seats to win a majority in the 577-seat National Assembly, and most polls projected Macron’s bloc would get close. But in the end, they got just 245, followed by 131 for the Nupes, then the National Rally’s 89 and finally the center-right Republicans’ 61.[ii] But even this is more fragmented than it looks, as Nupes isn’t a party—it is an alliance of the green, center-left and far-left parties. The four participating parties agreed to field only one candidate in each seat, with candidates running under the alliance’s umbrella instead of their actual party. That alliance is already crumbling, with the participating parties shying away from leftist leader Jean-Luc Mélenchon’s desire to make the bloc a formal coalition in the assembly, as doing so could risk wiping out their parties’ identities and subsuming them into Mélenchon’s France Unbowed, which won the most seats among the four. That is a particular anathema to the center-left Socialist Party, which has been fighting hard against its own obsolescence since 2017, when Socialist presidential incumbent François Hollande didn’t even bother seeking re-election after his popularity plunged. So, most likely we will see Nupes splinter into four, with France Unbowed reportedly taking about 70 seats, followed by the Socialists, Greens and Communists.

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The Basic Lesson From the 1994 Parallel

“The biggest rate hike since 1994.” That is how the vast majority of financial news outlets described the Fed’s 75 basis point (0.75 percentage point or three-quarter point) rate hike this week. 1994, 1994, 1994. Yet none of the coverage we encountered took the time to explain what was going on then—the simple fact that the Fed last undertook a 75 bp hike then was apparently enough for context. That is rather a shame, in my view, considering late 1994 was an interesting stretch with some parallels to today. There were also plenty of differences, so I won’t argue anything here is a blueprint or predictive, but a trip down memory lane can help dispel the notion that the Fed did something inherently and automatically destructive this week.

Like 2022, 1994 was a midterm election year under a first-term Democratic president whose polling numbers were on the slide amid a raft of political infighting—a phenomenon that, as Fisher Investments founder and Executive Chair Ken Fisher wrote in Forbes at the time, “weakens faith in our institutions” and spurs volatility.[i] The S&P 500 didn’t fall nearly as much in 1994 as this year, but it came close to a correction, and stocks seesawed hard all year before finishing mildly negative. Yet economic growth was robust and unemployment was low—by all rights, things that should have inspired cheer.

However, they mostly fueled angst. You see, inflation was low, but the Fed—with Paul Volcker’s battle against inflation still relatively fresh in the Board of Governors’ memory—worried it wouldn’t stay that way. They worried not about monetary excess, but supply and labor shortages. They saw a strong risk that the US economy simply lacked the capacity to produce as many goods as the populace demanded. They obsessed over a metric called capacity utilization, which essentially measures the amount of slack in heavy industry, worrying it was too high—that companies couldn’t raise output without incurring significant costs in new equipment and facilities, which supposedly risked driving consumer prices higher. So, to prevent supply shortages from driving prices higher, they started hiking rates in February.

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A Quick Reminder: Feelings Don’t Foretell

The University of Michigan’s widely watched consumer sentiment index fell to 50.2 this month—the index’s record low, if the final reading confirms the preliminary estimate on June 24. This confidence measure matches other recent dour polls: See Bank of America’s June fund manager survey (73% of respondents anticipate a weaker economy over the next 12 months) or a Financial Times/University of Chicago Booth School of Business poll (nearly 70% of economists expect a US recession next year).[i] In our view, the U-Michigan index’s record figure is an opportunity to revisit an important lesson. Sentiment gauges are, at best, coincident—moods don’t foretell economic activity, and it is often wiser to view them as a sign of what markets pre-priced already than what is to come.

All components of the U-Michigan index fell in June, from the outlook on business conditions over the next year (-24% m/m) to consumers’ assessment of their personal financial situations (-20% m/m). Among consumers, 46% attributed their negative views to inflation—the second-highest share since 1981. Half of respondents “spontaneously” mentioned rising gas prices in survey interviews, up from 30% in May and just 13% in June 2021, with consumers projecting gas prices to rise by a median of 25 cents over the next 12 months. From a historical perspective, the U-Michigan’s sentiment measure undercut its prior record low of 51.7 in May 1980, amid that year’s recession.

Exhibit 1: Feelings at a New Low?

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The Good News and Bad News in Today’s Fed Move

Will it be 50, 75 or 100? In the run-up to Wednesday’s Federal Open Market Committee rate decision and presser, that was the debate. Not whether they would hike, but by how much—50 basis points (bps, or 0.50 percentage point), as Fed Chair Jerome Powell intimated in May? Or would they be more aggressive, aiming to tighten policy in an effort to cool inflation? In the end, they opted to go bigger, hiking rates by 75 bps—the biggest single hike since 1994. With the S&P 500 entering a bear market earlier this week (breaching -20% from January 3’s high), many now fear the Fed erroneously and aggressively tightening against this backdrop means a recession is coming. While we understand that logic, it seems like a hasty conclusion, in our view. Let us explain.

First, while this downturn is now officially a bear market, it still looks mostly sentiment-driven to us. An unusually wide array of worries has taken turns dragging markets lower this year. Inflation. Putin’s vile Ukraine invasion and fears of wider war. Oil, commodity and other goods shortages. Chinese lockdowns. Eurozone economic weakness. Political worries. All have, at times, dominated discussion—unlike typical downturns, which generally feature one or two fears.

But after last week’s US consumer price index acceleration surprised many pundits, worries of hot inflation triggering an even more aggressive Fed returned to the fore. Some, as today’s Q&A with Powell suggested, even think the Fed is trying to induce a recession to slow rising prices. (A notion the Fed Chair repeatedly rejected.) These fears stoked big swings last Friday. And, on Monday, market-based expectations shifted swiftly toward a 75 bps hike and stocks tumbled below the -20% threshold that technically marks a bear market.[i] Now, to be clear, there isn’t anything about rising rates—whether short or long—that automatically dooms stocks. The relationship is vastly overrated. But it does seem to have roiled sentiment, especially as some alleged the upturn in expectations was based on leaked information emerging during the Fed’s media blackout period. Regardless, Treasury yields jumped, pricing in the rumored action, with 3-month yields rising from 1.26% last Tuesday to 1.83% yesterday, on the cusp of today’s announcement.[ii] 10-year yields similarly rose from 2.98% to 3.49%.[iii]

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Italian Debt Catches the ECB’s Eye

When global stock and bond markets entered this year’s rough patch, it was probably only a matter of time before investors returned to a long-running source of worry: Italian debt. Any time eurozone bond yields rise, people worry Italy’s debt woes will return, with soaring borrowing costs rendering the country unable to finance its debt—and resurrecting the eurozone debt crisis. So it went this week as Italy’s 10-year yields jumped past 4.0%, leading to an emergency ECB meeting Wednesday to address the issue. In typical eurocrat fashion, the bank announced a plan to have a plan but offered scant detail, leaving observers guessing. Time will tell what exactly they roll out, but we don’t see much evidence Italy needs the help.

Pundits were a bit surprised last week when the ECB didn’t address Italian debt at its regularly scheduled meeting. Italian 10-year yields exceeded 3.0% at the time, and debt fears were already percolating. The bank’s silence, coupled with its jawboning about raising its policy rate later this summer, seemingly sent sentiment sharply lower, triggering that jump over 4.0% for the first time since 2013, as the eurozone crisis wound down. (Exhibit 1) Hence, today’s emergency meeting.

Exhibit 1: Italian Yields in Context

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The ECB’s Hiking Path Isn’t That Rocky

Normally, central bank actions to move short-term interest rates to 0% wouldn’t constitute “tightening.” Yet that is what many seem to believe since last Thursday, when the ECB announced its intention to hike policy rates by 25 basis points (0.25 percentage point) at its July meeting and beyond. With its deposit facility rate currently at -0.5%, markets are expecting that to hit 0% by September. Many blamed the ECB’s announcement for European stocks’ sharp selloff late in the week. In this case, while 0% is higher than -0.5%, that doesn’t mean monetary policy is becoming more restrictive. Rather, we see it as a move back to normal after years of negative rates, which could very well bring some benefits.

The ECB has three benchmark rates it uses to conduct monetary policy: its main refinancing operations (MRO), marginal lending facility and deposit facility. The MRO rate is what banks pay to borrow from the ECB for a week. This borrowing is collateralized, meaning banks must provide the ECB with eligible assets to guarantee the loan. The MRO rate is currently set at 0%. The marginal lending facility rate is banks’ overnight borrowing cost, which is also collateralized, but typically costs more, now 0.25%.

The deposit facility rate determines what banks receive for keeping funds at the ECB overnight. Notably, this rate has been negative since June 2014—which means banks have had to pay the ECB to store their money. Imagine paying your bank a 0.5% annual rate to hold your deposits—a bit unusual and perverse. The ECB has set this rate progressively further below zero—starting at -0.1% eight years ago and bottoming at -0.5% from September 2019 onward—in an attempt to spur lending. This may sound promising: Penalize banks for storing cash at the central bank as a prod for them to lend instead. But the experiment hasn’t worked out that way. It has backfired, weighing on lending—not prompting it—which is why we think the ECB’s aim to remove negative rates is a blessing in disguise, putting an end to a long-misguided “extraordinary” policy.

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Accounting for (Rule) Differences

Among the lesser-seen worries in the cornucopia garnering investors’ ire lately hides S&P 500 Financials earnings’ -19.9% y/y plunge in Q1 2022—a highly unusual development during a stretch where most economic indicators are on an upswing and the vast majority of sectors are enjoying earnings growth.[i] The culprit, as The Wall Street Journal examined last weekend, is both simple and complex: A relatively new accounting rule is distorting earnings math bigtime. Interestingly, unlike the last time an accounting rule change distorted bank earnings, US Financials are actually holding up better than the S&P 500 overall. That is a change from 2007 – 2009, when another accounting rule destroyed bank balance sheets, triggering the global financial crisis. Understanding the rules’ differences can help investors get a better grasp of both past and present, in our view.

The rule in question is known as Current Expected Credit Loss, or CECL. As the name implies, it requires banks to account for all reasonably expected losses in their loan portfolio based on current economic conditions. Before CECL came on the scene, banks had to recognize—and provision for—loan losses only when they were imminent. While this system worked well for decades, following the 2007 – 2009 financial crisis, some industry critics argued banks were late to acknowledge trouble in their loan portfolios. In our view, they were misinterpreting the havoc wreaked by another accounting rule—FAS 157, the mark-to-market accounting rule, and its illogical application to illiquid and hard-to-value assets that banks never intended to sell. But cooler heads rarely prevail in these matters, so regulators decided the best way to shore up banks’ defenses would be to require them to provision for all expected credit losses over a loan’s entire lifetime.

What this means, in practice, is that banks must constantly adjust a given loan’s probability of default, usually based on current economic and financial conditions—and on the presumption that these conditions will last indefinitely. This has led to some outsized swings in banks’ earnings—swings that don’t totally reflect actual economic reality. In early 2020, at the height of lockdowns, this led to banks ratcheting up default projections and beefing up loan loss reserves accordingly. That was a big contributor to falling bank earnings early that year, as these provisions are basically paper losses. But a year later, with economies more open and an alphabet soup of fiscal and monetary assistance programs in place, expected defaults plunged, enabling banks to reduce their loan loss provisions—a paper gain. Now, high inflation and rising interest rates are again raising default projections, contributing to S&P 500 bank earnings falling -30.7% in Q1 2022.[ii] At some point in the future this will flip again, delivering a paper fillip to earnings.

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