BMO Private Bank
APRIL 2016
Outlook for Financial Markets
“There is only one success…to be able to spend your life in your own way.”
– Christopher Morley
Summary
Economy
Even though the presidential debates have
painted an image of a U.S. economy that is
dying on the vine, the actual state of affairs
is not half bad. Although retail sales edged
just 0.2% higher in January, according to
the Commerce Department, some of the
underlying U.S. consumption trends are
promising. Now that gasoline is so cheap
and the strong dollar has kept inflation at
bay, restaurant revenues are more than 6%
higher than they were last year. Perhaps no
surprise given our smartphone fetish, Internet
sales enjoyed an 8.7% surge. With the shift
toward dining away from home and making
purchases online, expect our nation’s malls
to transform into gigantic food courts.
There is hope that the consumption-heavy U.S.
economy can overpower the global economic
headwinds buffeting the manufacturing
sector. Widespread concern about the health
of the economy has led to trouble in stock
markets, while credit concerns are sending
corporate borrowing costs higher. Nevertheless,
the improvement in home sales, labor conditions
and wages suggest the U.S. economy is more
resilient than harried investors perceive.
Bank stocks have been particularly hard hit
this year amid fears that negative interest
rates in Europe and Japan will suppress
lending margins. The MSCI World Bank Index
is off more than 20% since August, double the
drawdown of the broad market in that time.
The energy sector had been a major source of
U.S. investment spending and employment,
but that’s clearly over now that the oil price has
collapsed by 70%. Even if those fuel savings get
spent in shopping malls and on the Internet,
consumer spending has a lower “economic
multiplier” than infrastructure expenditures.
The Chinese slowdown, amid its shift to a more
consumer-oriented economy, is evidence of this
14%
United States
Japan
Eurozone
10%
“You name the price, I’ll name the
terms.” In and of itself an outsized
debt liability to foreign creditors isn’t
necessarily a financial threat. As long as
the borrowing sovereign controls its own
currency, the “terms” can be changed.
Public companies hire accountants
like movie stars hire plastic
surgeons. On close inspection the
enhancements and augmentations to the
income statement are readily apparent.
“Speak softly and carry a big stick”
may have accurately reflected
Theodore Roosevelt’s non-aggressive
foreign policy, but it certainly doesn’t
hold true for today’s central banks.
A better phrase these days may be
“talk big and hope you don’t have to
back it up.”
Exhibit 1 » Cumulative Real GDP Growth since the Financial Crisis
12%
Europe’s failure to climb sufficiently
above its economic pre-crisis peak is
one of the reasons investors are nervous
about the global economy.
8%
6%
4%
Smart beta sponsors sport strong
hypothetical performance histories,
but critics fear investors may be buying
the best ideas of yesteryear.
2%
0%
-2%
-4%
-6%
2008
2009
2010
2011
2012
2013
2014
Source: Bloomberg; BMO Private Bank Strategy
A P R I L 20 1 6
phenomenon. Nevertheless, Americans are
stepping up spending in a variety of categories
including vehicles, groceries and building
materials. January represented the fourth
consecutive month of impressive increases.
The eurozone economy is also expanding,
courtesy of a 25% cheaper euro and
expansionary monetary policy. The 19-country
consortium grew at an annualized 1.1% rate in
the fourth quarter as German strength offset
weakness in Italy and France. For 2015 as a
whole, the region grew 1.5%, according to
Eurostat. Nevertheless, investors are worried
that the European Central Bank’s negative
interest rate strategy could threaten the
region’s banks and weigh on growth. It’s been
a hard slog. The size of the European economy
is only now – after all these years – getting
back to where it was in 2008. Of course the
eurozone remains burdened with problem
loans, dwindling liquidity and a reluctance
of policymakers to enact politically difficult
economic policies to spur business expansion.
Europe’s failure to climb sufficiently above its
economic pre-crisis peak is one of the reasons
investors are nervous about the global economy
(Exhibit #1). Adjusting for inflation, Eurostat
data show the eurozone generated economic
output of €2.465 trillion (U.S. $2.788 trillion)
in the last three months of 2015, essentially
the same as the €2.471 trillion produced in
this quarter eight years ago. Many fear the
current recovery in Europe will not be strong
enough to offset the malaise in China, for
example. While Germany and other northern
countries such as Denmark lost just a bit of
economic ground in the crisis, countries to
the south like Spain, Italy and Greece remain
far below their pre-crisis high-water marks.
Bond Market
“You name the price, I’ll name the terms.”
In and of itself an outsized debt liability to
foreign creditors isn’t necessarily a financial
threat. As long as the borrowing sovereign
controls its own currency, the “terms” can be
changed. High-profile debt difficulties tend to
involve borrowers who don’t have control of
their own printing press or who took out credit
in foreign currencies. In short, a country like
Greece could have liquidated its obligations
via inflation had it stuck to the drachma.
Puerto Rico is in a similar predicament,
stuck inside the U.S. with $70 billion in debt
and no control over the Federal Reserve.
The creation of trillions of dollars in new money
in recent years enabled emerging market
borrowers to skip the banks and go straight to
the bond market. Over the last 10 years, the
portion of emerging market debt funded by
bonds doubled, according to the International
Monetary Fund. Many of the bonds were issued
not in local currency but in U.S. dollars. The
Bank for International Settlements estimates
that there are $1.1 trillion in dollar-denominated
bonds issued by non-bank emerging market
companies, up from roughly $500 billion at the
end of 2008 (Exhibit #2). The implications are
mixed. Since the bonds are held by a large pool
of global institutional investors the risks are
spread across a range of holders rather than
concentrated with a handful of global banks.
Nonetheless, Fed tightening fueled a dollar rally,
putting additional pressure on emerging market
borrowers. We don’t anticipate a repeat of the
1998 Asian Contagion, but emerging economies
will feel the weight of dollar-denominated debt.
Equity Markets
Public companies hire accountants like movie
stars hire plastic surgeons. On close inspection
the enhancements and augmentations to the
income statement are readily apparent. That’s
been especially true over the past few earnings
seasons. According to Factset Research System
and the Wall Street Journal, S&P 500 companies
posted earnings per share results that rose a
scant 0.4% in 2015. However, under generally
accepted accounting principles (GAAP), earnings
actually declined 12.7%, the worst showing since
2008.
Why is there a difference between reported
earnings and GAAP earnings? Companies prefer
to use “pro-forma” figures, which exclude
one-time charges, with the definition of
“one time” often being left to interpretation.
Managements assert that pro-forma results
give shareholders a better view of profits from
ongoing operations without the confusion that
can come from unusual events. The problem
is that they’re the ones who determine what
is unusual or rare, often resulting in a liberal
interpretation of what gets included and what
gets left out. Needless to say, pro-forma results
almost always look better than GAAP figures.
In fact, S&P 500 pro-forma earnings for 2015
were 33% higher than comparable GAAP figures,
the widest differential since the financial
maelstrom (Exhibit #3). This disparity distorts
analysts’ interpretation of the market’s value.
For example, the market’s price-earnings ratio
using pro-forma earnings is 17, roughly in line
with historical norms. However, the GAAP P/E
ratio is 21, a historically expensive level.
Exhibit 2 » Debt Reckoning
The divergence in economic fortunes between
northern and southern Europe carries with it
political consequences. While wealthy countries
like Germany have been espousing debt
reduction and austerity, poorer neighbors to
the south have pleaded for public spending
to boost growth and create jobs. France
has recovered most of its lost ground since
the crisis, but the Socialist government has
been reticent to institute labor reforms that
could encourage entrepreneurship. There
are bright spots. European consumption has
rebounded and the Continent desperately
needed the gift of collapsed energy prices.
Source: Bank for International Settlements; WSJ.com
Outlook for Financial Markets • April 2016
2
A P R I L 2016
Employing the price-to-sales ratio offers an
even more sober view of the market’s current
valuation – and we like to refer to it because
sales are more difficult to nip and tuck than
other numbers on the income statement. At
its peak last year the S&P 500 was trading
at 1.8 times its sales, about 25% above its
20-year median according to BMO Private Bank
calculations; the figure has only slipped to 1.7
despite the market’s losses. Whether you use the
GAAP P/E or the price-to-sales ratio, the market
is expensive.
Exhibit 3 » THE GAAP GAP
Outlook
“Speak softly and carry a big stick” may have
accurately reflected Theodore Roosevelt’s nonaggressive foreign policy, but it certainly doesn’t
hold true for today’s central banks. A better
phrase these days may be “talk big and hope you
don’t have to back it up.” The Federal Reserve,
European Central Bank and Bank of Japan
have been running out of ammunition and are
resorting to rhetoric to reshape investor behavior.
Japan’s recent foray into negative interest rate
territory failed to impress investors, creating a
dilemma for Bank of Japan Governor Haruhiko
Kuroda. Central bank power is centered on real
and perceived perceptions, but recently the
Bank of Japan appears to have neither. Decades
of deflation created a notoriously vicious cycle
whereby people in Japan would postpone
spending because they anticipated prices would
decline, the very act of which reinforced the
price declines. It’s been a quarter century and the
central bank is still trying to create inflation; the
battle is daunting because so many years of low
prices have ingrained attitudes.
Five central banks have introduced negative
interest rates since 2012. According to Strategas
Research, in four of those five cases the
stock market of the negative-rate country
underperformed global equities over the
subsequent year. That’s because negative
interest rates typically come at the worst
possible time for economies and banks. Rates
go so low in the first place because borrowers
stop demanding loans. This causes monetary
authorities to do things like move rates into
negative territory, charging lenders for reserves
they keep on deposit at the central bank.
While the move crimps bank profits in the near
term, policymakers believe that subsequent
economic growth would more than offset
the near-term profit problems. However, in
reality, such draconian moves tend to amplify
fears of a widespread economic downturn,
3
Source: S&P Dow Jones Indices; FactSet; WSJ.com
putting pressure on the banks. Negative
interest rates threaten banks’ net interest
margin, the differential between deposit rates
and loan rates. German banks earn roughly
three-quarters of their income from that
rate differential, according to statistics from
the Bundesbank. Investors are being forced
to grapple with an economic conundrum:
weakened banks may not be strong enough
to stomach lower rates, while the economy
isn’t strong enough to handle higher rates.
Investors digesting the recent moves into
negative interest rates by central banks in Europe
and Japan are fearful of holding bank stocks.
Concerns that European banks are running short
of an adequate capital cushion came to light as
Deutsche Bank, Germany’s largest bank, omitted
its dividend for the first time since World War II.
Some hope that the near-term negatives to the
banks of negative rates will be ameliorated by
the long-run economic growth that low rates
would cause. In reality, this is often just wishful
thinking. Experimental strategies carry the price
of unintended consequences. In the case of
“quantitative easing,” massive monetary creation
runs the risk of inflation; a condition the Federal
Reserve had a three-decade track record of
taming. Negative interest rates run the risk of
savings account withdrawals, as citizens choose
to earn 0% with the cash hidden in their house
or buried in the back yard. In a system in which
banks only have to keep reserves on a fraction
of their deposits, such a bizarre bank run would
be apocalyptic.
roughly $2 trillion, most of which came from
the traditional mutual fund market. Since the
financial crisis, fund companies have rolled out
“smart beta” funds, which are tailored to suit
specific strategies instead of a passive index.
Smart beta funds tend to focus on fundamental
attributes like companies with high dividends,
momentum or low correlations, to name a few.
Morningstar estimates that nearly $73 billion
flowed into smart beta funds last year.
Smart beta sponsors sport strong hypothetical
performance histories, but critics fear investors
may be buying the best ideas of yesteryear.
ETF companies have tended to target strategies
that have outpaced the market in recent years,
leaving these strategies overly popular and in
many cases expensive.
Low-volatility stocks were unloved and cheap
leading up to the early 2000s when they were
available for half the broad market’s valuation.
After 15 years of outperformance, low-volatility
stocks now trade at a 20% premium to their
peers, according to a recent Wall Street Journal
report. The math is simple: pay too much for an
investment today and returns will be weighed
down in the future.
In this industry we often hear that past
performance is not indicative of future results.
That is certainly true when strategies or
investments get pricey. Needless to say,
even though we are intrigued by smart beta and
cheer this latest innovation, we always
take top-shelf historical performance with a
grain of salt.
Financial Market Strategy
Exchange-traded funds (ETFs) represent the
latest frontier in collective investing, amassing
Jack A. Ablin, CFA
Chief Investment Officer, BMO Private Bank
Outlook for Financial Markets • April 2016
Jack A. Ablin, CFA
Executive Vice President and Chief Investment Officer, BMO Private Bank
As Head of Macro Strategy, Jack chairs the Asset Allocation, Mutual Fund Re-Optimization and Harriscreen
Stock Selection Committees and is responsible for establishing investment policy and strategy within
BMO Private Bank throughout the U.S. He joined the organization in 2001 and has three decades of experience
in money management.
Jack earned a bachelor’s degree from Vassar College in New York, where he graduated with honors with an
A.B. in Mathematics and Computer Science. A member of the Beta Gamma Sigma International Honor Society,
Jack received an M.B.A. with honors and graduated cum laude from Boston University in Massachusetts.
He holds the Chartered Financial Analyst designation and is a member of the CFA Society of Chicago.
• Author of Reading Minds and Markets: Minimizing Risk and Maximizing Returns in a Volatile Global Marketplace, published in July 2009
by F.T. Press; Wall Street Journal’s best-seller list, 2009
• Frequent contributor to CNBC, Bloomberg, The Wall Street Journal and Barron’s
• Served as a Professor of Finance at Boston University, Graduate School of Management
• Spent five years as a Money and Markets correspondent for WTLV, the NBC affiliate in Jacksonville, Florida
• Named one of the Top 100 Wealth Advisors in North America by Citywealth magazine, in 2006, 2010 — 2015
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•All the views expressed in the research report accurately reflect his/her personal views about any and all of the subject securities or issues; and
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Written: March 3, 2016