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Divergence inspires volatility while a Nestlé Eurobond defies gravity

Posted: 2nd March 2015

BARCLAYS_COL 300dpiThe fast lane and the slow lane

We have highlighted two salient themes recently, the first is that divergent growth trajectories of the major economies will necessitate an associated divergence in monetary policy of the major central banks. Second, the rise in financial market volatility will likely accompany interest rate normalisation. In the first matter, the idea was simple: stronger growth in the United States would require a return to normalised interest rates (that is to say, numbers that do not start with a zero), whereas in Europe and Japan, monetary policy would have to remain extremely accommodative as each region struggled to generate enduring economic momentum. The idea behind the second is equally straightforward: when money has a price, markets discriminate. To be sure, investors behave differently when capital has a cost; their repositioning of assets in light of this causes price volatility; and uncertainty rises as a new consensus struggles to be formed in light of the new interest rate regime.

Both of these themes appear to have taken root in the thinking of G20 members at their confab held recently in Istanbul, Turkey. A draft communiqué from the summit obtained by Reuters cautioned:

“In an environment of divergent monetary policy settings and rising financial market volatility, policy settings should be carefully calibrated and clearly communicated to minimise negative spillovers…”

Translation – memo to policymakers: Don’t make a mess of what comes next. The US’s divergent growth trajectory from the rest of the world is coming into sharper relief with every passing week.

The US employment report for January was impressive. An additional 257,000 people joined the workforce, beating the expectation of a 228,000 rise. Since more workers entered the labour market, this pushed the unemployment rate slightly higher as more people were encouraged by the prospect of finding a job. Moreover, the three-month average job growth was the highest recorded in 17 years.

Another measure of labour market health lends support to the January jobs report. In its Job Openings and Labour Turnover Survey (“Jolts”), the Bureau of Labour Statistics (“BLS”) revealed that job openings in December 2014 hit the highest level since 2001. Encouragingly, over the course of 2014, jobs rose in every region the BLS surveyed. Perhaps daydreaming a bit: it is interesting to note that there are roughly 9 million people looking for work and roughly 5 million job openings. If only those looking for work could be matched with those looking to hire…but this is the stuff of another note.

The bottom line in all of this supports our long-held belief that the Federal Reserve will begin raising interest rates at or before its June meeting. Given the recalcitrance of central bankers to act decisively in resetting interest rates, a June hike is most likely, though the Fed will have more than enough justification to start the process before then.

It is interesting to note the price action of the trade-weighted dollar and gold this year. Both moved in tandem at the start of the year. Since the end of January, there has been an increasing divergence between the two, as gold investors appear to be reconciling themselves with the reality of higher interest rates. To be sure, the dollar becomes an even more attractive “crisis asset,” a role that gold has traditionally played, when dollar assets hold the promise of a yield.

Hope amidst the headlines

In the euro zone, green shoots of hopeful economic data continue to sprout. The Organisation for Economic Cooperation and Development (“OECD”) released its December reading of its Composite Leading Indicators. These suggest “…tentative signs of a positive change in the growth momentum in the Euro area…” The report highlighted the “positive change” in growth momentum for Spain and Germany, with stable growth momentum in Italy and France. Investors appear to have anticipated some of this, as the Euro Stoxx 50 Index has gained 7.78% this year.

A non-Newtonian world of finance

An article in The Financial Times caught my attention and has stuck with me like the melody of a bad song. The article made mention of a Nestlé Eurobond trading at a negative yield. This is noteworthy, as the phenomenon of negative yields in the euro zone has spread from the sovereign to the corporate debt market. For those who believe in the “old ways,” investing should produce positive returns on investment; the idea of investing in anything with a negative yield is hard, if not impossible, to understand. In an attempt to comprehend the incomprehensible, I put Nestlé under examination. (Note: the following is not a buy or sell recommendation. It is simply an attempt to make sense of someone’s decision to commit precious capital to an investment that if held to maturity will produce a loss.

Nestlé SA is Switzerland-based multinational food company. It manufactures and markets everything from pet food to candy. The market capitalisation of the company is roughly 23 billion Swiss francs (“CHF”) or approximately 24.8 billion USD. Revenues for the 2013 fiscal year stood at 92.2 billion CHF. Investors in the stock collect a dividend yield of roughly 3.01%. Moreover, a quick check reveals the company raised its dividend every year from 2005 through 2013. The earnings yield is 4.18%. Finally, the stock is down 2% for the year so far. Compare the stock of the company with its Medium Term Note issued on October 17, 2012: the 0.75%’s of 10/17/2016 offered at 101.331 produces a yield to worst for the buyer of -0.0446%. It’s not a misprint.

The driver of negative yields in the sovereign bond markets is the European Central Bank’s (ECB’s) extraordinary monetary policy. The rush of money from the ECB’s various forms of quantitative easing has leaked into the corporate bond market, as the case of the Nestlé bond demonstrates. The presumptive motivation of buyers of these wealth-sapping instruments is that in a world of falling prices and repressed interest rates, there might be an opportunity to sell them to another buyer at a higher price, should the deflationary pull within Europe strengthen.

This strikes me as the greater fool strategy of buying something with no apparent economic value, only to sell it to the next in line at a higher price, hoping that the purchaser is more willing to suspend belief and the principles of mathematics. Incredibly, investors who would find the bond attractive appear to be turning away from Nestlé’s income-producing stock.

Newton is dead. The theory of gravity has been repudiated.

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