News from Europe

Brexit Upends Global Markets

The U.K. vote to leave the European Union shocked financial markets, here are our thoughts:

1) The U.S. stock market is taking things in stride relative to declines globally with the U.S. market falling back to where it was just one week ago. Some of the largest declines have taken place in European stocks(-10.50%), European banks (-15%), the British Pound (-8%) and Japanese stocks (-7.7%). Fortunately these were areas of the market we have been avoiding. On the flip side Gold, U.S. Treasuries and the U.S. Dollar have all been benefactors of the vote to leave with strong gains today.

2) Britain's vote to leave was not that surprising if you looked at how close the polls were going into the vote, however global markets had strongly rallied for five straight days on the assumption the Remain vote would win. Bookmakers in the U.K. put odds at almost 80% that Remain would win going into the vote. Moving forward the U.K. will not begin to exit the EU until October and even then the process will take several years.

3)  What will be interesting to watch going forward will be to see what impact, if any, this vote will have on politicians in Italy, Spain, France etc. It is possible there will be a push for similar referendums. The leading candidate in the race for Prime Minister in the Netherlands today said he will be calling for a referendum to leave the EU if he wins. The Netherlands have had five straight years of GDP growth under 1%.

On a related note, growth has continued to be abysmal in Europe. European Central Bank President Mario Draghi has repeatedly voiced frustrations that while the ECB has implemented program after program to try and boost the economy politicians have not passed pro-growth reforms. Draghi specifically has mentioned reforms in areas like labor laws, tax policy and pensions.  

Sluggish economic growth was not the primary reason for Brexit. However it did play a factor and the longer politicians in other European countries go without implementing pro-growth reforms the more probable it becomes that the status quo in those countries will be upended.   

4) Odds of a Federal Reserve rate hike in 2016 plummeted from 42% to 18% this morning after the Brexit vote. The awful May jobs report had taken a summer rate hike off the table. For now the odds of a hike at any time in 2016 are low. It will take much stronger U.S. economic data in the 2nd half of 2016 for a hike to occur.

The volatility that has come with Brexit is in the process of producing some attractive investment opportunities. Caution is still warranted though, as a key question to be answered will be what degree of impact this vote will have on business confidence, as one of the drawbacks of sluggish economic growth is that it leaves very little margin for shocks to the system. The U.S. economy has been able to overcome global hurdles over the past 5 -6 years and continue to plod forward with 2% GDP growth. We will be watching the data as we enter the 2nd half of 2016. 

S&P 500 Back Into Familiar Territory

This Spring has had no shortage of market-moving stories. Notable among them, The U.S. Dollar Index, which measures the U.S. Dollar vs a basket of other currencies, declined from 100 in early February to 93 in early May. This weakening of the dollar fueled gains in stocks, oil and commodities. We will have more on this in a future post. Speaking of oil, it has made a strong comeback off its February low of $27/barrel climbing to $49/barrel today. There are still significant supply hurdles that will have to be overcome for oil to avoid revisiting the $30's.

On to other topics...

The S&P

The S&P 500 is back in a trading range it has seen twice before over the past year. 

So what has kept the the S&P from breaking out of this trading range to the upside? Last August it was the Chinese currency devaluation that triggered a market sell-off and then in the first week of 2016 the Chinese devalued their currency again beginning another market fall below the trading range. Over the past few months the Chinese have taken back tight control over their currency so another devaluation in the coming months is less likely, though can't be ruled out. 

Another key point- declining revenue and earnings over the previous four quarters have also kept the S&P from breaking out. Some analysts project that the 7% earnings decline seen in the first quarter was the low point and that companies will have a much stronger second half of the year. This has been projected for several years but has failed to materialize. That being said, there are CEOs who are optimistic. 

The Fed

The market focus over the next few weeks will once again be on the issue of whether the Federal Reserve will raise interest rates at their June meeting. Just in the past week market participants have placed the odds of a Fed rate increase from 4% to a 32% chance today. This shift began after Fed meeting minutes were released last Wednesday that showed Fed officials were much more open to a June interest rate increase than the market had previously anticipated. In addition to the Fed minutes numerous Fed officials have been talking about the need for 2-3 rate hikes this year. The Fed has put themselves in another position in which they need to follow through and increase rates at the June meeting to try and restore some of the credibility they have lost with the many flip-flops we have seen from them in the past few years. 

The Fed claims to be data dependent, though it certainly has become much more market dependent under Janet Yellen. Looking at the data, first-quarter GDP was very weak at a .5% annual pace, first-quarter retail sales were poor and the April jobs report fell short of expectations. However, U.S. economic data has improved recently with a strong April retail sales number, good industrial numbers and April new home sales which rose to the highest level since 2008.

To reiterate our position, the 0% interest rates put in place during the 2008 financial crisis were for emergency measures and the Fed made a mistake waiting until December 2015 to begin the process of increasing rates. The economy was strong enough in 2013 & 2014 to begin slowly increasing rates from 0% to 1%, still a very low rate but off the emergency level. The Fed didn't do that and now has found themselves with a more challenging job.


Every few years around this time market volatility has picked up and all of us have been subjected to hearing endless media conjecture about Greece and the question of will they or won't they be bailed out. The market won't be fretting over a Greece bail out this year because it has been taken off the table. From the WSJ:

"Eurozone finance ministers and the International Monetary Fund patched together a deal in the early hours of Wednesday that clears the way for fresh loans for Greece and sets out how the country could get debt relief in the future.
The ministers, who held an 11-hour meeting in Brussels, said Greece had done what was necessary to unlock the next slice of financial aid, concluding a review of its bailout that was delayed for months. The new payouts will save Greece from defaulting on big debt redemptions to the IMF and European Central Bank in July."

What happened here is the politicians in the EU didn't want to have this battle with Greece right now, so they gave Greece $11 billion so Greece wouldn't default on previous bailout loans. Greece is in a hole they will not be getting out of and this move is another classic illustration of kicking the can down the road.

Going forward all eyes will be on the Fed and their June decision. Based on the Fed minutes, unless the economic data in the coming weeks is just dreadful, they have put themselves in a situation where a rate increase is needed for multiple reasons, their credibility being the most important. Regardless of what the Fed decides to do, we will be paying attention.

Financial Stocks Lead Market Decline

It has been another rousing week here at Sentara Capital with the financial headlines changing by the hour. 

Behind the scenes during more volatile times in the markets we are monitoring client portfolios to insure that losses are contained. If there are individual positions that are suffering steeper losses than we anticipated then we will make adjustments. We have been very pleased with the results so far this year, but it is an ongoing process. Market declines are not all created equal, the playbooks change, the investment mix that worked well before won't necessarily work well the next time. Market conditions change over time and that is why it is imperative for us to continue to closely follow them. It gives us the ability to create a new playbook instead of relying on a previous playbook.

Chinese markets were closed for the Lunar New Year holiday this week but that didn't mean global markets were in for a calm week. Japanese stocks led the way lower, with their worst week since 2008, down 11%. The Bank of Japan surprised investors on January 29th by announcing negative interest rates, meaning banks would have to pay the central bank to keep excess reserves at the central bank. Since that time investors have sold bank stocks concerned that negative interest rates would lead to a very challenging environment for the sector.

Also weighing on the market this week was Deutsche Bank, Europe's largest bank, which continued to see its share price fall, down almost 40% in just six weeks. This company has been on our radar screen since last summer when their CEO abruptly quit after just one month on the job. Since then the stock has been collapsing, the company reported operating losses for calendar year 2015 and is facing regulatory hurdles. Add to this concerns that the company has over $70 trillion of derivatives exposure and it is not difficult to see why Deutsche Bank has led the banking sector in Europe down 30% year-to-date. 

Big U.S. banks have declined 20% and have led our markets lower, taking the mantle from energy companies which were the primary drivers of lower prices early in the year. Today Jamie Dimon, CEO of JP Morgan, bought $26 million of JP Morgan stock, which lifted shares of JP Morgan and other bank stocks. There is no question that the balance sheets of U.S. banks are very strong, but the market is clearly concerned about the impact lower interest rates, European bank problems, and slower Chinese growth will have on U.S. banks. 

A few noteworthy items:

Gold: The precious metal has rallied to $1,239/oz, up over 8% in the last week alone. Gold has been in a bear market since 2011 so this recent rally is the first real strength the metal has seen in some time. We will be watching to see if this strength can be sustained.

The Fed:  Coming into the year the Fed signaled their intent to raise interest rates four times in 2016; however the market is now pricing in a less than 25% chance of even one interest rate increase in 2016. 

Meanwhile bond rates have had a steep decline since the start of the year on worries of weak global growth and deflationary concerns. The yield on the 10-year U.S. Treasury has fallen from 2.28% on January 1st to 1.70% today. It is worth nothing that the drop in bond rates accelerated when the Bank of Japan surprised investors on January 29th by announcing negative interest rates. For more on negative interest rates I suggest you click here.

The U.S. Consumer: The Commerce Department reported Retail Sales grew .2% in January, a 3.4% increase over last year. This was a strong showing by the U.S. consumer and a much needed bright spot to the economic data that has been released so far. Any fears that the U.S. is in a recession right now can be put to rest with this report.  

The decline in stocks here in the U.S. have brought valuations back to very reasonable levels and certain sectors have become cheap for the first time in a long time. That being said, the market is at a key technical level which means a level where buyers have been coming in to keep the market from further declines. Over the next few weeks it will be important to see if this key technical level can hold as more developments unfold concerning the Europeans banks and the Chinese economy.

As always we will be closely watching and taking care of your portfolios.    

Greek Drama Strikes Again

As we reach the midpoint of 2015 let's take a look at some of the financial topics making headlines:

1) Greece- In what has been an annual occurrence for the past five years, Greece has taken center stage once again. In January the Greeks elected the radical Syriza party, who promptly stated that they would not abide by the terms of prior agreements with the European Union. The party's platform included raising taxes, a significant increase in government spending, increasing government pensions, free electricity to all Greeks and refusing to make certain loan payments to creditors. It was many of these same policies that put Greece in the perilous position they find themselves in. 

We have made the point for many years that Germany gave the Eurozone the blueprint to economic growth fifteen years ago with pro-growth reforms. Unfortunately, the majority of European countries have not followed suit and continue to struggle with high taxes, excessive government spending and rigid labor markets. The results have included very sluggish economic growth and high unemployment.

Greece's Prime Minister Alexis Tsipras has called for a referendum on July 5th where Greeks will decide whether or not to accept creditors' austerity demands. If they vote no a Greek Eurozone exit would seem to be inevitable. Greek banks will remain closed all week as the government tries to prevent a banking system collapse.

It is important to remember that Greece's economy is very small, similar in size to the Detroit metro area. With this being the case it wouldn't seem that Greece leaving the Eurozone would cause a significant market disruption. However, in a financially interconnected world a seemingly minor financial event can begin a chain reaction that causes much larger market stress. 

2) China- China's Shanghai Composite is now down 22% over the past two weeks, sending Chinese stocks into a bear market. When you look beneath the headlines you will find that even after the 22% fall stocks are still up 25% year-to-date and have doubled over the past year. In recent weeks signs that Chinese stocks had run too far too fast were all around. Two examples- reports of Chinese farmers trading stocks instead of tending to their crops and margin debt crossing over $350 billion as Chinese investors borrowed money to invest. Investors who borrowed on margin can be forced to sell after market declines as institutions recall their loans. This selling can lead to larger market losses. 

3) United States- Stock markets in the U.S. remain in a tight trading range. Since mid-March both the Dow Jones Industrial Average and the S&P 500 have traded in a range of 3-4 percent with buyers stepping in at the lower end of the range and sellers emerging at the higher end. The longer stocks stay range-bound the stronger the break-out move tends to be, regardless of whether stocks break-out to the upside or the downside.

S&P 500

S&P 500

What are some of the issues that could trigger a break of the trading range? How strong will 2nd quarter earnings reports be, will interest rates continue their move higher and what will be the ultimate fall-out behind the scenes if Greece defaults?

These are just a few of the developments that will be worth monitoring in the coming months. Keep in mind that on topics ranging from Greece to China to U.S. earnings reports it is important to look beyond the headlines, where the important information lies.

Italian Lending Increases

The European debt crisis reached a boiling point last summer until European Central Bank President Mario Draghi announced that the ECB would do "whatever it takes" to save the Euro. Since then bond yields have dropped significantly in financially troubled countries like Spain and Italy. Pro-growth reform is still badly needed and while the financial crisis is not over and the majority of the Eurozone is still in a recession, it is encouraging to see lending to small and mid-sized businesses picking up in Italy. We will continue to watch carefully for more positive developments. For more click here:

March Madness

In my family, March Madness is our favorite time of the year. My wife typically makes a delicious basketball cake in early March for me and the boys. Both of my boys completed a bracket this year and are faring better than I am, something my youngest is reminding me of on a daily basis.

In the spirit of March Madness, here is a graphic that depicts how the stock/bond markets are impacted by different variables:

stocks sweet sixteen

The first quarter was very strong for the stock market with healthy gains and low volatility, almost a carbon copy of the first quarter last year.  The S&P 500 and the Dow led the way while bonds and gold struggled.  In 2010, 2011 and 2012, the US stock market peaked during one of the four weeks of April.  In each case economic momentum slowed down, fears from Europe resumed and a stock market correction of between 10 and 19% ensued. That being said, 2013 is a different year and the massive amount of money being printed by central banks across the globe could help keep any market pullbacks shallow.

In recent weeks I have repeatedly been asked if investors in the United States should be concerned about the economic unrest in Cyprus. If you have not been paying attention here are two articles that discuss the situation in Cyprus:

Cyprus is a tiny country, but in this particular case the response from the European Central Bank to Cyprus' request for bailout funds is why an investor needs to pay attention to what is going on.  In the recent past, banks in Greece, Spain, France, Portugal have called upon the European Central Bank(ECB) for bailout funds.  But for the first time the ECB has demanded a one-time tax on individual bank deposits in return for the bailout money Cyprus requsted.  Up until this point bank deposits in Europe have been insured, much like FDIC insurance here in the United States.

Now that the ECB has put seizing individuals bank deposits on the table as a prerequisite for bailout money the question is will the public's trust in the banking system in countries like Italy, Spain and France begin to decline.  If so, the public could begin to withdraw their funds from local banks en masse and the European crisis could come back into focus. I am not predicting what will happen, and if history is any indication the ECB may come up with another temporary "solution" (shorter-term stopgap) that tries to contain any fall-out from the Cyprus debacle.  We will continue to monitor this situation very carefully.

Central Banks in 2012

We first want to wish you a Merry Christmas and Happy Holidays!There are so many financial stories from 2012 but one has trumped all in the eyes of the financial markets. It has been a year when Central Banks around the globe have printed an unprecedented amount of money.  As you can see since 2008, Central Banks balance sheets have exploded.  This truly is an economic experiment since we have never seen this level of Central Bank intervention before.  This year the stock market has paid little attention to a struggling jobs market, weak economic growth and declining earnings expectations and has rallied on the surge of money in the system. 

Inline image 1

The financial markets have paid little attention to the European debt crisis of late, due in large part to the European Central Bank's aggressive money printing.  However, as we have repeatedly pointed out nothing has been "fixed" in Europe.  

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First up, European GDP has tended to track US GDP growth, but there has been a wide divergence in the past year.  The US has slowly recovered while Europe continues to contract.

Source: Kit Juckes, Societe General

Next up is a chart of GDP growth in the large Euro countries.  Notice while Germany continues to grow, Italy and Spain continue to deteriorate.  All of the money printing by the ECB can temporarily deflect attention from Italy and Spain but unless these countries change course and pursue policies to stimulate growth the crisis will return.

Inline image 3

Source: Laurence Boone, Chief European Economist BoA Merrill Lynch

Lastly, Europeans support of the Euro has dropped from over 80% to 53%.  If this trend continues it will be problematic for European leaders, who are trying to solve the crisis..

Inline image 4

Source: Nomura Securities

More Stimulus Please

It has been an action-packed two weeks with a variety of economic/political events. Let's get to it.

1)  The European Central Bank announced their latest attempt at solving the Euro debt crisis.  This time the ECB stands ready to buy an unlimited amount of Euro-zone governments' bonds.  From The Guardian: The scheme is aimed at depressing the costs of borrowing for Spain and Italy and countering the risks of a fragmentation of the eurozone and the unravelling of the single currency.  But Draghi also set strict terms for triggering the bond-buying programme, putting pressure on the eurozone's political leaders to request help, enter austerity programmes, and agree on direct bailouts for struggling governments before the ECB will act.

For more on the ECB's announcement:

The ECB is saying that if a struggling country agrees to cut government spending and agrees to other restrictions, the ECB will buy an unlimited amount of that government's bonds.  The problem, as we have seen in Greece, is that the governments in Europe have a very hard time implementing the spending cuts and sticking to the restrictions.  If spending cuts and reforms are not implemented then you have a transfer of wealth, via the ECB, from stronger countries like German, Belgium and The Netherlands to weaker countries like Spain, Italy and Greece.

As we have said from the beginning of this crisis, it is challenging to identify a scenario where this does not end badly.

2)  The August jobs report was disappointing with only 96,000 new jobs added and a downward revision to the previous two months.  The Unemployment Rate dropped from 8.3% to 8.1% but this was largely due to discouraged workers dropping out of the labor force.  

For more commentary on the fourth poor jobs report in the last five months:

3)  Finally, the Federal Reserve meets this Wednesday and Thursday and may announce further monetary stimulus for the economy.  The Fed has already had two official rounds of bond-buying (QE) and a third round called Operation Twist. There is a spirited debate about whether the Fed will announce a QE3 this Thursday.

Here are both sides of the debate:

Why QE3 won't be announced this week:

On top of all of this we are keeping our eyes on the impact of the election, the looming Fiscal Cliff and Apple's upcoming product line, as all three events will have an impact on the stock and bond markets.

Europe... past and present.

Spanish bond yields continue to hover just under 7%, an unsustainable level.  European Central Bank President, Mario Draghi, ignited a stock market rally with his comments two weeks ago that the ECB would do "anything it takes" to save the Euro.  Last week the ECB met but did not take any new action to help stem the crisis and that is a major reason that Spanish bond yields have not had a significant drop.  My take is that after Draghi made his remarks the German Finance Minister reminded him that currently they are not willing to to do "anything it takes" to save the Euro as that would mean Germany standing behind the debt of countries like Greece, Spain and Italy. The German people are not in favor of writing a blank check to their Euro neighbors, nor is the German Finance Minister.

As a refresher, the German economy was in real trouble ten years ago and then Chancellor Gerhard Schroder began reforming the country by lowering taxes, reducing stifling regulations, reduced welfare programs and cut down on the level of government spending.  These reforms were not popular at the time and there were some difficult times immediately following implementation.  Chancellor Schroder stuck with the reforms and the German economy began to flourish.  I bring this up because today Spain, Italy and France, among others, have a choice.  The choice is whether or not to go in the direction that has worked so well for Germany or double down on the policies that have brought so much pain to the Eurozone, such as high taxes, excessive regulations, extremely high levels of government spending, etc.

In France, President Francois Hollande is proposing a 75% tax rate on the highest income earners.  This is not a recipe for increased economic growth.  Here are a few of the important points from a New York Times article addressing France's economy:

- “French people have an uncomfortable relationship with money,” Mr. Grandil said. “Here, someone who is a self-made man, creating jobs and ending up as a millionaire, is viewed with suspicion. This is big cultural difference between France and the United States.” - They also know of companies — start-ups and multinationals alike — that are delaying plans to invest in France or to move employees or new hires here. - Taxes are high in France for a reason: they pay for one of Europe’s most generous social welfare systems and a large government. As Mr. Hollande has described it, the tax plan is about “justice,” and “sending out a signal, a message of social cohesion.” - “The thing French politicians don’t seem to understand or care about is that when you tax away two-thirds of someone’s earnings to appeal to voters, productive people who can enrich businesses and the economy won’t come — or they will just leave,” said Diane Segalen, a corporate headhunter.

Good news as the U.S. housing market continues to improve. Checking back in with Bill McBride at Calculated Risk: