Earlier today I posted that the more dovish than expected news from the Federal Reserve on Wednesday, March 16–a signal that the Fed was looking at two interest rate increases in 2016 rather than the four it had projected in December–had, in the shorter run, set off a rally in those asset classes that benefit from a weaker dollar–commodities including oil and gold, for example, and emerging market debt and equities. Today that trend remained in effect although, this being a Friday after a good run to the upside, pre-weekend selling has taken some of the strength out of that rally. As of 1 p.m. New York time the Dow Jones Industrial Average was up 0.5% and the Standard & Poor’s 500 stock index was ahead 0.49%. In the oil markets West Texas Intermediate was holding even and Brent benchmark crude was up 0.6%. Emerging market stocks, as measured by the iShares MSCI Emerging Markets ETF (EEM), were higher by 0.78%.
However, in the longer run, I noted, the global economy is still looking at a tightening of the supply of dollars. The Federal Reserve, after all, didn’t say it was about to cut interest rates or that it had decided not to raise rates at all in 2016. It announced that it would move more slowly–but that it still intended to raise interest rates. That means that a sluggish global economy is still looking at the Federal Reserve to tighten the supply of dollars–and thus to make them more expensive–in 2016, probably beginning at the Fed’s June 16 meeting. The Fed’s caution on raising rates is a reminder that the world economy runs on dollars and that the Fed, the central bank for the United States, recognizes that because of the dollar’s role as the dominant global currency it is the central bank for the world too. As much as the strength of the U.S. economy might argue for interest rate increases, the weakness of the global economy, the Fed said on Wednesday (actually fairly clearly for the Fed) isn’t ready for higher U.S. interest rates. A hike in interest rates and a stronger dollar would amount to a tightening of monetary policy for the world–and the world economy, in the Fed’s estimation, isn’t strong enough for that.
In the longer run then, the Fed’s move yesterday isn’t a big plus for all the asset classes that are up today and were up even more yesterday. The Fed’s worry about the effects of a U.S. interest rate increase should remind us that the stronger dollar that is likely to follow on such a move (all things being equal, which, of course, they never are) will act, at a minimum, to depress the prices of commodities denominated in dollars such as oil, copper, and gold.
But that effect isn’t the big worry in the current global economy. During the days when interest rates on the dollar ranged from 0% to 0.25% companies in developing economies borrowed in dollars to meet working capital requirements, to build factories, and to expand marketing efforts. In Brazil, for example, borrowing in overseas markets by non-finance companies reached a record $137 billion in 2014, the Bank for International Settlements reported in September 2015. That’s a 10-fold increase in the last decade.
Brazilian companies have been alone in this trend. In 2014 Indian companies borrowed $20 billion overseas, bringing total outstanding overseas borrowing to $200 billion. Much of that, an estimated 50%, is unhedged and rises or falls in value with the Indian rupee. That $100 billion in unhedged overseas corporate borrowing is equal to roughly 5% of India’s GDP.
In China unhedged overseas corporate debt came to $1 trillion at the end of 2014, UBS estimates. That’s equal to roughly 10% of China’s GDP.
This unhedged debt burden gets really heavy when the local currency plunges against the dollar. The Brazilian real fell 32.9% against the U.S. dollar in 2015, making every dollar of corporate debt roughly one-third more expensive to pay back. Other big currency drops in 2015 hit the Argentine peso (34.6%), the South African rand (25%), the Turkish lira (20%) and the Russian ruble (17%).
The corporate sector isn’t the only part of developing country economies exposed to the effects of high U.S. interest rates and a stronger dollar. Any country running a current account deficit and thus dependent on external cash flows to balance its accounts also feels the effect. A Brazil, a Turkey, or an India, for example, needs to attract overseas capital–and that gets harder when the local currency is tumbling and when local interest rates lag those in the United States.
Some developing country central banks tend to fight this problem by raising their own interest rates, a study by the Dallas Federal Reserve Bank, found. Mexico’s central bank raised its benchmark interest rate 0.25 percentage points on December 17, following hard on the heels of the Fed’s December 16 0.25 percentage point increase. Raising domestic interest rates does work to defend the local currency, the Mexican peso in this case, but higher domestic interest rates do take a bite out of domestic economic growth. Central banks are most likely to raise interest rates–and take the potential punishment to the domestic economy–if their national economy is dependent on overseas cash flows to balance the current account. The list of countries likely to take that uncomfortable deal, according to the Dallas Fed, includes Turkey, South Africa, Peru, Mexico Colombia, Brazil, Chile and India. I’d note that this list uses data from 2014. I think if you factor in the collapse in oil prices, Russia and Nigeria would be members of this group.
All this means, of course, that any move by the U.S. Federal Reserve to raise U.S. interest rates comes with a built in multiplier that increases the slowdown to global growth (from any slowdown in U.S. domestic growth) because of the potential drag from these coincident developing economy interest rate increases.
The other multiplier here operates through the mechanism of sovereign debt and national credit ratings–and it’s here that we pick up another big effect from the global slowdown in economic growth. The slowdown in the global economy has brought especially big drops in economic growth for developing economies dependent on demand from China and/or global commodity prices. A country such as Brazil, which had clawed its way to its first ever investment grade credit rating during the boom years has seen itself plunge back to a below investment grade credit rating. Countries that have to compete in the global markets to raise money to fund their government operations then have to pay more when their debt is graded as “more risky” and when investors have a choice of buying higher yielding and safer U.S. debt. (Safety, or perceived safety, goes a long way in the debt markets these days–how else explain the propensity of the currency and bonds of the heavily indebted (understatement alert) Japanese government to climb when investors and traders think global financial markets have turned riskier.)
None of these longer-term drags on emerging financial markets and their economies went away with the Fed’s dovish surprise on Wednesday, March 16. Their effects may have been postponed. And the drags may have decreased in magnitude with the decision, at the moment, to move to two increases in 2016 from four.
What’s difficult to calculate right now is what degree of drag was already accurately priced into crushed prices in emerging markets–in which case the explosive rally of the last two days is fundamentally justified. On the other hand, there’s the strong possibility that fundamentals have nothing to do with this rally and that it is all based on speculation and momentum.
In the last month or so as emerging market asset prices plunged, I’ve heard more and more talk of the drop in those prices setting up the trade of the decade. I’m not discounting the potential truthiness of that talk. But I sure would like to figure out whether we have one more plunge ahead as the fundamentals of the Fed’s interest rates bite home or if now is the time to buy into these assets (and as a trade or as an investment?) And I’d like to figure out which emerging markets carry the most and lease risk (and of what sort) so I can figure out what I might want to own or not.
I’ll take a stab at answering some of those questions in a post tomorrow, Saturday, March 19.
In the short-run (however, long that might be) financial markets have decided to jump on the “dovish Federal Reserve” band wagon.
Thursday, the dollar was down again and (as of 2 p.m. New York time) showed its biggest two day loss since 2009. The euro had climbed to $1.1320 today from a close of $1.1224 Tuesday.
Everything that normally goes up with a weak dollar was up. The West Texas Intermediate crude benchmark climbed to near $40 and was up 3.77% as of 2 p.m. Emerging market stocks had climbed by 2.2% (as measured by the iShares MSCI Emerging Markets ETF (EEM) as of 2 p.m. in New York on Thursday. As if to demonstrate how in favor the riskiest assets are Brazil’s Sao Paulo market was ahead 5.97% for the day as of 2 p.m.
In the short-term this all makes sense. The Fed’s decision to leave interest rates unchanged at Wednesday’s meeting of its Open Market Committee and its signal of its intention to raise interest rates just twice in 2016 instead of the four times it planned back in December does promise the world that the Fed will raise rates very, very gradually and that the Fed will remain in the easy money camp along with the Bank of Japan, the European Central Bank, and the People’s Bank of China for longer than financial markets anticipated back in December. And I suspect that there’s a very sizable group of traders that believes the Fed will pull back even from its plan for two interest rate increases in 2016.
Easy money from the Fed means a weaker dollar means rising prices for commodities priced in dollars, means substantial relief for companies in developing countries with large amounts of dollar-denominated debt and means welcome help for central banks in those economies trying to walk the line between raising interest rates to defend their own currencies and risking an even greater slowdown in economic growth from those higher interest rates.
In the short-term a Fed that is moving more slowly toward raising rates is a big plus for all these asset classes. And that’s reflected in market action of the last two days.
In the longer run (however shortly that might arrive), the Fed’s caution on raising rates is a reminder that the world economy runs on dollars and that the Fed, the central bank for the United States, recognizes that because of the dollar’s role as the dominant global currency it is the central bank for the world too. As much as the strength of the U.S. economy might argue for interest rate increases, the weakness of the global economy, the Fed said yesterday (actually fairly clearly for the Fed) isn’t ready for higher U.S. interest rates. A hike in interest rates and a stronger dollar would amount to a tightening of monetary policy for the world–and the world economy, in the Fed’s estimation, isn’t strong enough for that.
In the longer run then, the Fed’s move Wednesday isn’t a big plus for all the asset classes that are up in the last two days. Instead it’s a signal of how vulnerable these asset classes are to any increase in the strength of the dollar and any increase in U.S. interest rates. The only reason not to be worried, in the longer run, about the Fed’s move Wednesday, is if you believe the Fed will, because of global economic weakness, decide to put off even the two interest rate increases it signaled for 2016 yesterday.
But that’s another perspective and another blog post. The next one up, in fact.
The longer the financial markets thought about the actions announced by the European Central Bank today, the less impressed markets were. The STOXX 600 Europe Index had climbed as much as 2.5% during the day, but after peaking around 1 p.m., the index finished down 1.7% for the day. The French CAC 40 ended lower by 1.7% and the German DAX was off by 2.3% at the close.
The problem was that European Central Bank President Mario Draghi undercut, as far as the market was concerned, more forceful than expected action with his comments to reporters. The bank announced another 10 basis point cut to its overnight deposit rate to a negative 0.4% (as expected); raised the amount of assets it aims to buy each month to 80 billion euros from 60 billion (10 billion more than expected) and that it would add corporate debt to its potential purchases.
Nothing startling there but more than expected.
But Draghi then said that the central bank is done–at least for a while. “From today’s perspective, we don’t anticipate it will be necessary to reduce rates further,” he said. The package “is an adequate reaction to a weakening of the growth and price-stability prospects,” Draghi added. “We think the measures we took today are adequate to address the change in economic conditions that occurred since our last monetary policy meeting.”
Which seems puzzling since he also noted that inflation is expected to remain negative (deflation in other words but without saying the “d word) in the coming months but will pick up later in 2016. (Inflation in February was a negative 0.2%.) The central bank lowered its inflation forecast for 2016 to 0.1% from the 1% forecast in December. Inflation will climb to 1.3% in 2017 and then 1.6% in 2018.
Last time I checked the math 1.6% is still less than the 2% target the bank has set as a goal for its program of asset purchases. And the bank is now projecting that inflation will remain below that target through 2018.
The European Central Bank also cut it forecast for economic growth in the EuroZone to 1.4% in 2016. That’s below the 1.7% growth in GDP the central bank forecast in December. The EuroZone economy will grow by 1.7% in 2017.
So let’s see–inflation lower than the target and economic growth tepid into 2017. Yep, I can see why the European Central Bank announced that it was done for a while.
On the news the euro climbed to $1.1207 against the dollar–after falling by as much as 1.6% earlier.
The most important take-away to me from today’s announcement and the market reaction is that traders and investors are becoming increasingly skeptical about the ability of central banks to stimulate higher growth and to generate higher inflation.
The bag of tricks announced today by the European Central Bank didn’t contain anything new and the same old, same old–even more of the same old, same old–doesn’t have the old magic that it once did.
Most technical indicators say we’re in a bear market. Whether you want to call it a rolling bear, or a consolidation, or pick nits since the Standard & Poor’s 500 as a whole hasn’t yet hit the down 20% territory now inhabited by many of former market leaders. (The February 12 issue of James Stack’s InvesTech Research newsletter does a superb job of summarizing the technical indicators pointing to a bear market. To check out Stack’s newsletter and/or subscribe go to investech.com)
But so far economic indicators aren’t pointing to a U.S. recession. Job growth and income growth are healthy. Although the Institute for Supply Management’s survey of purchasing managers in the manufacturing sector has fallen below the 50 mark that indicates contraction in the sector, the survey for the services sector hangs above that mark, despite recent weakness. In the housing sector the confidence survey for the National Association of Home Builders hasn’t shown the downturn that usually proceeds a recession.
This is a good moment to remember Nobel-prize-winning economist Paul Samuelson’s quip that “The stock market has forecast nine of the last five recessions.”
Why is this important?
Stocks can certainly experience a bear market without a recession so the fact that the economy may not enter a recession isn’t some kind of proof that stocks aren’t actually in a bear or headed for one. (The S&P 500 is hanging around a drop of 13% or so in a bad week–not bear market territory–but 60% of S&P member stocks are 20% or more off their highs.)
But the worst bear markets in terms of percentage drop and in terms of duration require a coincident recession. If the U.S. isn’t going to slide into recession, the bear that is breathing down our necks right now will probably resemble a deeper version of the 12.4% drop from the May 21 high of 2130.82 on the S&P 500 to the August 25 low at 1867.61.
By November 2 the S&P 500 had climbed back to 2109.79. Painful certainly but not terribly long-lasting.
To get a really, really painful and long-lasting bear you need to combine a drop in stock prices with a recession as we did in 2007, 2000, and 1980. The 2007 bear–and the Great Recession–took stock prices down 56.8% and lasted for 517 days, according to Yardeni Research. The 2000 bear resulted in a 49.1% drop and lasted for 929 days. The 1980 bear took stocks down 27.1% and lasted 622 days.
Now that’s pain–and the duration of that pain was enough to test–if not wash out–even the most steel-nerved of investors.
So the big question for 2016–after the horrendous start to the year–is will we get a U.S. recession in 2016?
I wish I could confidently scoff and say “No way,” but I can’t. I think a U.S. recession in 2016 is unlikely–but it certainly isn’t impossible.
The economy, I’m afraid could go either way–although I think the odds are in favor of “No recession.”
As I noted above job growth is very solid and income growth actually looks like it is starting to pick up. Low oil prices mean low gas prices mean more dollars in consumers’ wallets for spending on things other than fuel. The U.S. auto industry set a sales record in 2015 and doesn’t look poised to fall off a cliff in 2016. After it’s best year in a decade in 2015, the U.S. housing industry is forecast to see 1% to 3% sales growth in 2016. That’s not a house on fire but growth isn’t recession. U.S. interest rates are low–and I think it’s likely that the Federal Reserve will pause its rate increases until it sees signs that U.S. growth is a solid 2% or so. Right now forecasts call for earnings growth to resume in the second half of 2016 as year-to-year comparisons with the slow growth of the second half of 2015 make beating estimates easier. That would have a big positive effect on CEO confidence levels. That’s important because worried CEOs fire people and don’t invest in their businesses. A modest increase in oil prices to, say $45 a barrel, would take pressure off some oil companies and reduce worry over banks’ exposure to bad loans in the energy sector.
That’s not a forecast for rip-snorting economy in the second half of 2016–but it is a picture of an economy that isn’t in recession.
Unfortunately, none of those positive trends or news items is a lock. China’s economy, despite the current round of stimulus, is likely to continue to slow. The U.S. economy doesn’t look like it will get any help from Japan and a EuroZone growth recovery is possible but questionable and won’t produce big numbers in any case. Developing economies and commodity-oriented economies such as Australia and Canada are likely to struggle. There is the possibility of a beggar-thy-neighbor round of currency devaluations that would further hurt U.S. exports. We’ve got weak governments coping with big problems in the EuroZone, the Middle East, Russia, and Japan. And I certainly would never rule out that U.S. politicians might be something stupid in an election year that might hurt U.S. growth. Nor can I absolutely rule out the possibility that the Fed got it wrong when it decided to raise interest rates in December.
It’s going to be hard to tell what the economic trend line is over the next few months because beginning in March we’re likely to see splashy moves from the central banks of the EuroZone, Japan, and China. I think all three of these central banks are signaling that they will move strongly in the early spring to stimulate their own economies. The likelihood is that will rally stock markets for a while but then leave markets open to a return to the crisis of confidence that I see in the financial markets right now. To my eyes a big part of the current slide in global stocks markets is due to investors and traders losing confidence in the ability of central banks to produce growth in their economies or to prop up the prices of financial assets for very long. That could see us return to the current malaise after the failure of a promising rally in the spring. That kind of volatility will make it very hard to find a longer-term trend worth hanging onto.
I guess you could color me “hopeful” that the U.S. will avoid a recession–which would help investors avoid the worst kind of bear market–but worried that a recession is possible and that financial markets having lost faith in central bank policies will wander lower.
I certainly understand why the headlines focus on Thursday’s 7% drop in 29 minutes in Shanghai or the worst ever start to a new year by the U.S. Standard & Poor’s 500 or the plunge in oil to a 12-year low for West Texas Intermediate crude.
All this short-term stuff is very scary.
But frankly it’s not what worries me most at the moment. From a slightly longer perspective–six months or so–the current plunge in China’s Shanghai market is Stage 2 in what looks like a crisis of confidence for Chinese traders and investors.
After years and years stock markets would reliably rally from any plunge on actions by the People’s Bank of China and the Beijing government to support markets, in this Stage 2 the Chinese government isn’t having much luck with measures designed to rally stocks. Today, for example, government moves that would have in the past led to a rally recouping half or more of the week’ 12% plunge have brought the Shanghai Composite a gain of just less than 2%.
It’s clear that the Chinese government is getting less stock market bang for its intervention yuan.
Some of that is because of the truly inept policy decisions being implemented by the Chinese leaders.
And part of it is that Chinese investors and traders have come to recognize just how inept, badly designed, and self-contractory these policy decisions have been. In fact, on the evidence of early 2016, in the eyes of (some? many?) traders and investors the Chinese government has moved from the solution to market woes to the cause of plunging stock prices.
The financial markets look like they’ve lost faith in the institutions–regulators, the People’s Bank, the central government–that have in the past come to the market’s rescue.
If that’s the case we’re looking at a crisis in the Chinese stock markets that isn’t fixable by suspending circuit breakers or adding $20 billion to the money supply (as the People’s Bank did this past Tuesday) or announcing another list of new investments in airports or rail lines. And if that’s the case then we’re looking at a crisis that is capable of hamstringing China’s efforts at economic and market reforms that are essential to move China through the middle income trap that so frequently stalls developing economies.
And to the degree that this crisis is a crisis of confidence in China’s central bank (and associated financial institutions in China), then what we might be seeing is actually just the most visible signs of a global crisis as investors and traders lose confidence in the ability of all central banks to manage financial systems and economies. It sure doesn’t help global confidence that the policies of the Bank of Japan and the European Central Bank have been unable to achieve the goals announced by those banks.
Let me start with what I see happening in China and explain what I call Stage 1 and Stage 2 in this crisis.
Stage 1 starts with last summer’s plunge in the Shanghai market. The Shanghai Composite Index peaked on June 12 at 5166 and then plummeted to 2927 on August 26. That’s a drop of 43.3% in two-and-a-half months. The Chinese government responded with a familiar mix of policies almost immediately announcing, for example, a cut in benchmark lending rates and a reduction in the amount of reserves that banks need to keep against outstanding loans. That latter step is equivalent to adding cash to the financial system; the People’s Bank also directly injected yuan into the system using its open market operations. A few days after the initial moves, the central bank also announced that it would roll over 130 billion yuan in loans to bank, extend the maturity on those loans to six months from three months, and cut the interest rate on those loans by 0.15 percentage points.
Those moves were more aggressive than the efforts the bank has taken in earlier market plunges. And what’s important is that, this time, they didn’t succeed in ending the sell off.
To do that the People’s Bank and other regulators had to promulgate some very coercive commands directly to the market itself. Brokerage firms were ordered to avoid negative comments on the market. All scheduled IPOs were put on hold in order not to drain funds from already listed stocks. Owners of stakes bigger than 5% in a company were ordered not to sell. Investigations into brokerage firms and employees were launched the focused on conspiracies to forcing stock prices lower.
By August 26 all these efforts had succeeded in stabilizing the Shanghai market at 2927.
The recovery from that bottom took the Shanghai market back to 3642 by December 21. That’s rally of 24% and a retracement of more than 700 points of the 2200 points Shanghai stocks had lost from June 12 to August 26.
But the rally didn’t hold. And the market went back into a slump even more volatile that the June to August plunge. From December 21 at 3642 to the close on January 7, 2016 at 3125 Shanghai stocks gave up 500 of the points gained in the 700 point rally from the August bottom. The December 21 to January 7 drop added up to 14.2%.
Why call this Stage 2?
First, because the drivers of this drop are much the same as in the June to August drop.
Second, because the policy response by the Chinese government has, so far, been largely the same as in the June to August plunge.
And third, because this drop marks an escalation of some of the worries about the competency of China’s market regulators at the country’s central banks.
Let me go through the first two reasons quickly since I think you’ll be relatively familiar with this turf and so I haven’t moved too far into “eyes-glazed-over” territory by the time I get to reason three.
First, the causal connection. Remember that back in June-Augut the worries were the China’s growth rate was slowing; that a slowing global economy was depressing China’s exports and export-based economy; that a renminbi/yuan linked through the exchange rate set by the People’s Bank was causing China’s currency to appreciate (and again hurting exports); and that efforts to add necessary market reforms to China’s economy risked bankrupting some of the country’s biggest employers.
I think the current plunge has been based on a strikingly similar list of worries–with the addition of worries about the huge drop in China’s foreign exchange reserves as cash flees China in search of better or safer opportunities and as the People’s Bank burns cash in an effort to prevent the renminbi/yuan from falling too far, too fast. An uncontrolled drop in the currency would unnerve financial markets and make cash flow out of the country even faster. China’s foreign exchange reserves dropped by $513 billion in 2015 to $3.33 trillion. (And despite efforts to prop up the renminbi/yuan, $843 billion left China between February and November, according to Bloomberg.
Second, the policies being use to support the financial market in January include many of the same policy tools run out in June through August. That’s become extremely clear this week as the People’s Bank has added cash to the financial system–just as it has done in every previous bout of market turmoil and as it has pulled back on removing some of the measures it took in June-August to support the market then. The most obvious example of that was the decision to lift a ban on selling shares owned by investors holding 5% or more of a single company’s stock. That ban, left over from the June-August crisis was originally scheduled to be removed today, January 8 but regulators decided to leave it in effect for now.
And third, this time around investors and traders are seeing the incompetencies and policy failures of the People’s Bank and other regulators, which were present in the June-August sell off– exposed as never before. Think it makes trader feel confident about the markets and the people who run them when the country’s security regulator says about the new circuit breakers that made the plunges so much worse this week that it had imposed the policy despite having “no experience” in using this tool. (And when market rules already said no stock could fall more than 10% in a day.)
I’m seeing more and more questioning too–from financial professionals at companies inside and outside China–of basic policies at the People’s Bank. For example, how can the People’s Bank explain injecting cash into system in order to increase liquidity (and spur the economy) at the same time as its efforts to support the yuan remove cash from the system? (The People’s Bank buys renminbi/yuan to support the yuan which removes currency from the financial system and the economy since the bank finances those purchases with bonds.)
There’s a growing body of economic commentary that argues that by maintaing a managed link to the dollar, using the trading range established each day by the People’s Bank, China is effectively importing the Federal Reserve’s program of economic tightening into a situation where other officials are focused on loosening spending, lowering interest rates, and boosting growth.
Is anybody really in charge? Does anybody really know how to run this economy?
Those aren’t the kinds of questions that are good for a stock market trading at a median price to earnings ratio above 60. (The U.S. market, for reference, trades near 20.) Market valuations in China’s financial markets, dominated as they are by individual investors, have always priced in an assumption of effective government support for stock prices. If investors and traders start to lose confidence in their central bank and it’s policies, we’re likely to be looking at a long period of downward movement as that “confidence premium” is removed from the market.