Time to Trash the Negative Interest Rate Experiment?  Let’s step back and look at global stock markets in general and why we continue to believe that these gains are not sustainable.  The huge gains off the 2008 lows, which were initially driven by a global economic recovery, have become driven by higher valuations since 2012.  Fully 92% of the rally over the past four years can be traced to one driver—the collapse in “equity risk premium.”  This surplus premium that investors demand to justify the risk of owning stocks has shriveled as bond yields plummeted and central banks cut interest rates to zero and below.  In other words, it hasn’t mattered much that earnings for S&P500 companies peaked in 2014 and have stagnated since.  American consumers are propping up the economy as Europe’s growth stalls with the uncertainty over Brexit and the recent problems at Deutsche Bank and China’s credit and construction spending decelerates into 2017.  Investors desperately seeking yield have had to buy stocks, which has forced the average investor to take a much higher degree of risk in their portfolio in order to achieve what used to be called ‘normal returns.’  Now we start to hear some rumblings from Janet Yellen that the Federal Reserve could also look at buying U.S. corporate bonds as well as stocks in order to keep their easing programs in place.  How can having major central banks become buyers of stocks do anything outside of supporting the growing bubble being created in financial markets?   Just look at Japan to see how unsuccessful these types of policies have been.

Can a rally built not on earnings growth but on the continued repression of bond yields be sustained?  In the past, when unemployment was 4.9% or lower, the federal-funds rate had averaged 4.96% or more.  Yet today we have rates still below 0.5% with investors cringing over the idea that those rates could increase by another ¼ point!   Central banks have become the largest blind buyers in the world, accumulating trillions of dollars’ worth of assets with no thought of price, valuation or exit strategy.  The global financial system is awash in $12.3 trillion of negative-yielding bonds, and central banks now hold $25 trillion of financial assets, more than the combined gross domestic product of the U.S. and Japan.  What have all these aggressive policies done to actually stimulate economic growth?  Consider the evidence: The U.S. is in its seventh year of job creation, and unemployment is near a nine-year low of 4.9%.  But since 2010, workforce productivity has expanded at an annualized rate of just 0.4%—the most sluggish since World War II.  Wage growth barely keeps pace with weak inflation.  Real assets—such as homes owned by working Americans—are near all-time lows relative to financial assets, such as stocks and bonds.  Bubbles never end well.  The failed economic policies of these central banks have only succeeded in creating a massive bubble in financial assets.  Investors need to be aware of the risks!

Why we’re out of Canadian bank stocks, for now.  Bank earnings in Canada have more downside risk than upside potential in our view.  Valuations are near record levels, yet earnings growth has slowed down.  A red-hot housing market has helped consumers, wealth management and loan books but we see more risk of a material pull-back in prices.  U.S. investors seem convinced that our housing market, and therefore our banks, are at significant risk as they continue to add to record short positions in our banks.  While that investment has not paid off for them yet, we worry that they have a better perspective on the risks than Canadians are allowing for.   While capital levels in the banks are adequate, those may need to be increased due to regulatory risk.   Also, the banks have to deal with significant increases in technology spending to keep with the incurrence of competition coming from the new ‘FinTech’ players.

With the banks’ fiscal third-quarter financial results now in the books, it appears the banks have come through the commodity downturn relatively unscathed as loan losses incurred likely peaked in the second quarter.  .But there’s a reason no one has declared an end to the uncertainty over the energy-related fallout: When it comes to predicting oil prices, the banks are as useless as the rest of us, yet the biggest banks set aside considerably less money in the third quarter to cover bad loans than they did in the previous quarter.  Outside of the energy sector though, credit provisioning continues to build as many loans continue to deteriorate.  When we add all of this up, the high dividend yields of the bank stocks does not seem like enough cushion to offset all of the potential risks.

1 2