Martello Headline: Martello Investments recently launched its investment management business. We focus on data-driven, diversified strategies that can participate in upside while protecting investor capital in downturns.
Negative Rates: Investors continue to deal with the prevalence of negative interest rates in global markets. Fourteen countries ended April with 2-year government bond rates below 0. The impact of low interest rates on equity valuation is well understood, but it remains to be seen how the push to negative rates will affect equity valuations moving forward.
Markets: After a brief pause in March, April saw a continuation to the rally in equity markets. Domestic markets flirted with all-time highs despite tepid economic growth, prospects of further Fed tightening, and seemingly endless chaos in Washington. International equities were bolstered by an as-expected result in the first round of voting in the French PM election. Bond markets rallied, with benchmark interest rates falling and credit spreads continuing to tighten.
The concept of negative interest rates has gripped markets in recent months; there are now 14 countries with negative 2-year treasury yields. Switzerland currently has a negative rate on its 10-year bond while several other countries have 10-year treasury rates under 0.50%. To illustrate the mechanics of a negative interest rate, let’s consider a savings account with a negative rate. Instead of receiving interest on the saver’s balance at the bank, the saver must now pay interest for the privilege of holding their money at the bank. Indeed, the saver would be better off hiding their money under the proverbial mattress, though large corporations and pensions will undoubtedly never find one large enough to hoard all of their cash.
Setting aside the reality of negative interest rates as a market force, viewing them from the perspective of purposeful monetary policy shows the incredible desperation of many countries’ central banks. The purpose of setting benchmark interest rates, or deposit rates for that matter, below zero is to encourage current spending. From a capital outlays viewpoint, a company should use all available cash on any project or investment with a positive expected return in the face of negative interest rates; the opportunity cost is to forfeit money by paying a negative rate. Consumers face a similar choice, deciding whether to pay for deposits or spend their money by frontloading consumption. Furthermore, the negative interest rate should theoretically drive the cost to borrow money to incredibly low levels, further encouraging consumers and businesses to increase debt burdens to spend money today at the expense of future consumption.
A negative market rate, on a treasury bond for example, speaks to an entirely different situation. To be clear, a negative market interest rate is, at once, setting deflationary expectations while also stimulating asset prices. Expectationally, if an investor is willing to accept a negative interest rate, they are implicitly betting that prices will fall, and therefore that a dollar today is less valuable than a dollar tomorrow.
This phenomenon of future cash being more valuable than present cash has troubling consequences for equity valuation. If one views a stock as a claim on the perpetual earnings of a company, the present value of those earnings will ultimately drive what an investor is willing to pay for the stock. A present value calculation is incredibly sensitive to the assumed interest rate. For example, let’s evaluate a hypothetical example of an asset at different interest rates. Assume the asset pays $10 per year in cash flows, and that the terminal value of the asset at the end of 10 years is $100, for a total cash flow stream of $200 over 10 years. In a normal interest rate environment, an investor should be willing to buy that cash flow stream for less than $200 because the value of money in hand is higher than money expected in the future. Indeed, we can see that in the example below, the investor would be willing to pay $185.24 for this cash flow stream at a 1% discount rate. At a -1% discount rate, however, the investor would value the cash flows, totaling $200 over 10 years, at $216.30.
This clearly defies logic, but it is the reality in which a few countries currently reside, and many others could be heading. The problem here is that, if interest rates rise, the claim on these cash flows become significantly less valuable. If the trajectory of global interest rates eventually changes, the timing of which is of course impossible to know, equity markets could come under significant stress. We have seen this once before: in 1965-1975, U.S. bond yields rose significantly, which was accompanied by significant equity market volatility, including drawdowns of 21% (1965-1966), 36% (1968-1970), and 48% (1973-1974).
After a brief pause in March, domestic equity markets continued their steady upward trend, as the MSCI World Index returned 1.5% for the month. US Large Cap stocks, as measured by the S&P 500 Index, gained 1.0%. US mid-cap stocks, as measured by the S&P 400 returned 0.8% and the Russell 2000 small-cap index finished the month up 1.1%. The headline indices for Europe (STOXX 600) and the UK (FTSE 100) returned 2.0% and -1.3%, respectively. At the sector level, Technology (+2.5%) and Consumer Discretionary (+2.4%) led the way, while a large loss in crude oil sent the Energy sector down 2.9%. After rebounding from a weak 2015 with a strong return in 2016, Energy stocks are again under pressure so far this year, as the sector index has returned -9.4% year-to-date through April.
The S&P 500 wavered throughout the month, with U.S. air strikes in Syria and continued dysfunction in Washington sending the index lower by 1.4% through April 13th. An as-expected result in the first round of the French election calmed markets, though, as the S&P 500 rallied to post a 1.0% gain for the month. Market volatility, as measured by the CBOE Market Volatility Index (VIX), rallied into the mid-month but ultimately faded to close at 12.37, well below the long-run average of 20.
Despite the prospect of an additional rate hike by the Fed, bond market showed continued strength in April. The U.S. 10-year Treasury closed the month 10 bps lower at 2.29%, while the 30-year closed 6 bps lower at 2.95%. High yield credit spreads, as measured by the BofA Merrill Lynch US High Yield Option-Adjusted Spread, tightened by 17 bps to close April at 3.75%. The high-yield bond market has shown particular strength in recent months, as the index approaches recent lows.
The S&P GSCI Total Return Index returned -2.1% in April, dragged lower by Energy and Industrial Metals sub-indices, which returned -3.6% and -3.1%, respectively. The oil market continues to be a source of volatility in the commodity complex, driven by OPEC supply machinations and fluctuations in U.S. production and stockpiles. A mid-April report signaling an unexpected climb in gasoline inventories sent energy commodities sharply lower. Meanwhile, as OPEC attempts to extend its supply cut, the cartel seems unable to tame U.S. shale production, as U.S. oil output is anticipated to rise by more than 860,000 barrels per day in 2017.
Gold, on the other hand, continues to trade up on increased global socio-political risks and a weakening US Dollar. After rallying to over $1,294/oz. into the mid-month, gold faded to close April at $1,269.50/oz. The US Dollar Index traded lower throughout the month to close at 99.04, 1.5% lower than March’s close. The Euro rallied sharply against the USD following the first round of French elections, ultimately closing the month at 1.089 USD/EUR.
Martello Investments launched effective May 1. We utilize an adaptive, data-driven approach with an eye towards risk. We build systematic investment strategies that use market data to position our portfolios. By focusing on market trends, volatility, and systemic analysis, we hope to eliminate the emotional pitfalls of investing. This approach can help investors take risk off the table when markets show signs of weakening, while participating in rising markets in the interim.
We are excited to announce that Mark Finn and Bill Grant have joined us as Advisory Board Members. Both Mark and Bill have been important mentors to us through the years and we are pleased to have them on the team. We greatly appreciate and are humbled by the support and encouragement we have received so far.
Arthur Grizzle & Charles Culver