The summer of 2016 has been one of complacency. US stocks have drifted to record highs on numerous occasions and global equities remained broadly range bound.
Yet record highs haven’t been achieved by booming earnings or expectations of increased economic activity. Gains in equities have been caused largely by investors having little choice but to buy equities.
Subsequent to the UK’s decision to leave the EU, traditional safe haven fixed income asset yields have crashed and are offering pitiful returns.
Low bond returns
The low returns offered by bonds has driven investors into stocks, not because they are good value, but because they offer above sub 1% yields achievable in many 10-year government bonds.
This, in a nutshell, is the distortion to asset prices caused but ultra-accommodative global monetary policy. Such distortions never last forever, the Dotcom Boom is evidence of that.
The lack of risk events over the summer and the belief that the Federal Reserve haven’t got the bottle to hike rates has been the main driver 2016’s complacency. The latter could well be the first factor to unravel the recent stock market rally.
Federal Reserve Risks
The Fed hiked rates for the first time since the financial crisis last December. In the following months global equities plunged. There is a strong argument that the selloff was driven by numerous factors, which we come onto later, but the genesis was 16th December 2015.
Expectations built over many months the Federal Reserve would hike given the health of US economy and the recovery in stocks after the Chinese currency devaluation.
Despite economist’s expectations, the markets were clearly not ready and volatility spread through emerging market currencies and equites. Eventually this would spill over to developed world stocks causing the FTSE 100 to sink 4% on the very first trading day of 2016.
This reaction has since created a sense of security in markets the Federal Reserve wouldn’t be foolish enough to do such a thing again.
Futures Pricing
The market has priced little or no chance of hike this year throughout 2016. However recently Federal Reserve members have emphasised we should be prepared for an increase sending chances of a December hike up to 70%.
“Assuming the economic trends have not changed dramatically between now and then, we continue to see steady growth in the housing market, in consumer spending, and in the labor market, those are all very valid reasons to raise rates in December,” said Jennifer Lee, of BMO Capital Markets to Reuters.
This divergence in Fed rhetoric and market pricing is sowing the seeds for sharp re-pricing of equities.
If the Federal Reserve warnings prove credible and they do indeed hike at the September meeting, or any other meeting when the market isn’t prepared for a hike, the consequences could be dramatic for stocks.
The fallout will unlikely be contained in stocks with a spike in the dollar driving down commodity prices.
High pay-out ratios
The US Energy Information Administration has recently predicted an oversupply in oil lasting through end 2017. In some respects, oil over supply is old news.
Yet the latest release will cause concern among oil bulls who previously thought the oil market would have already reached an equilibrium.
“We continue to expect that oil prices will remain in a $45 per barrel to $50 per barrel trading range through mid-2017 with near-term risks skewed to the downside” Goldman Sachs recently said in a note to clients.
The consequences of lower for longer oil are far reaching. Firstly, it hasn’t produced the economic benefits lower fuel costs were forecast to have.
Secondly, and most importantly for equity markets, oil majors who have seen a steady decline in cash, will start to look at their dividend policies.
The FTSE 100 pay-out ratio of dividends is close to 100%. This means that on average, all FTSE 100 company profits are being paid out as dividends.
Yet due to their large constituency of London’s leading index, the problem is centred around oil companies such as BP and Shell.
The two are burning through retained earnings to keep shareholders happy, this can’t last forever.
If there isn’t a significant increase in the price oil by this time next year, these two investor favourites, and a raft of similar companies may be on the verge of cutting their dividends.
Such actions would roil markets and due to the large proportion of the FTSE 100 attributed to commodities, London leading index may be on the sharp end of a global correction.