10-15 Associates

Unintended Consequences – May 2015 Monthly Market Commentary

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By Deborah DeMatteo
Managing Director & Chief Investment Officer

We have learned a lot over the last several weeks as corporate America sheds light on the results from the first quarter. Most importantly we received a lesson in economics and the unintended consequences of monetary policy. Interest rates, currency volatility, central bank easing, and commodities were in the spotlight during much of the month. While the European Central Bank embarked on their own program of quantitative easing, interest rates around the world collapsed, raising new questions about the timing and ability of our Federal Reserve to raise interest rates later this year. The impact in the currency markets was a direct hit to US multinational’s earnings and the decline in global interest rates could create serious implications to the banking sector.

One problem that has emerged since the start of European quantitative easing is the drop below zero for interest rates in several countries. Negative interest rates have caused banks such as Bankinter SA, the seventh largest lender in Spain by market value, to credit interest on mortgages. Borrowers are benefitting as the banks are forced to reduce the outstanding loan balances on debt that had variable interest rates. In Portugal, another area facing negative interest rates, more than 90% of the 2.3 million mortgages outstanding have variable rates. Banks there approached the Central Bank for guidance and assistance and it was ruled that banks must credit interest to borrowers on any debt that the variable rate falls below zero. In Denmark, Erhvervsbank announced plans to charge retail customers to hold money in their deposit accounts. Although this is the first bank and so far only one to do so, several banks have stopped issuing some types of mortgage backed bonds. Some customers have already begun to remove their deposits, but in a statement by the banks chief financial officer: “Paying our customers zero or positive interest is very bad for profitability.” Lower interest rates aimed at stimulating borrowing will not work if lenders aren’t willing to make the loans.

As European rates dropped below zero, our Federal Reserve was watching the economic data in the US continue to show troubling signs to the recovery. Markets, nervous about the future moves of the Federal Reserve, began selling bonds this month sending US rates higher. The 10-year Treasury’s yield during the month rose from 1.857 to 2.032, representing a 9.39% increase in rates in just a months’ time. More importantly the close over 2% is a move much closer to the higher end of the range that we have traded this year, leaving investors wondering which direction we are headed. Earlier this year we had already experienced unprecedented volatility in interest rates and April continued the trend. With so many industries’ buying decisions tied to the cost of borrowing, volatility creates confusion and lack of certainty; which can lead to a slowing in the economy.

The US dollar has also been caught in the crosshairs of central bank monetary policy. Year-to-date, the dollar has appreciated against the euro by just a little over 7% causing trouble for our big multinational companies that do a large part of their business outside the US. The currency impact too many companies was even greater than expected. DuPont, in its first quarter earnings announcement referenced the effect of currency more than once: “DuPont delivered first quarter operating earnings per share of $1.34, which includes a $.25 per share negative impact form currency in segment results. Sales were $9.2 billion, down 9% versus prior year primarily due to impacts from currency. Estimated negative currency impact in 2015 increased approximately $.80 per share, up from the $.60 per share we previously communicated.” This was not unlike most other multinationals reporting earnings this quarter. However, in April we did see a turnaround with the Euro gaining a little over 4% versus the dollar. The question now looms whether the dollar has peaked and negative currency issues are behind us, or will the second quarter bring another leg down for the Euro?

After all the hand wringing and calls for Armageddon in the oil market, April saw a sharp reversal in oil prices. Fears of $20-$30 per barrel oil prices in January and February have quickly turned to fears of oil back over $70 in the very near term. Brent and WTI traded at $57.1 and $50.1 at the beginning of the month. By the time we close out April prices had risen to $66.8 and $59.6, respectively, representing a 16.9% and a 19.1% increase! The idea of a catalyst in the form of energy cost savings quickly began to dissipate. The surge in spending that everyone had hoped for never appeared and oil this past month began to move aggressively back in the other direction. All the layoffs are on the books and the unemployment lines are growing in the oil producing states, but the reality of some help to the broader economy has begun to slip away. Oil related stocks have been swept along for the ride adding to the daily volatility we saw during the month.

It should be of no surprise with all of the global macro issues that the markets have failed to make any real progress. Given some of the details above it may be more surprising that the stock market has taken it largely in stride. Until commodities, interest rates, and currencies exhibit a larger degree of stability, stocks will remain be holding to the headlines . Transitioning away from the massive amount of stimulus over the last several years will not be easy, but it is the direction we want to head. A world, in which central bank commentary is no longer the front page headline, is something we should all look forward to.

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