More on Market Volatility

Despite the fact that the U.S. economy appears to be on solid ground, the equity markets appear confused and uncertain, and have exhibited volatility, including huge intraday point swings.  In what follows, I will examine the sources of the uncertainty and try to shed light on whether or not to worry.

   1.  Global Economic Conditions are Deteriorating

• Europe has 11%+ unemployment and is wrestling to avoid recession.  In fact, it was only the redefinition of GDP last year to include the underground economy (drug dealing, prostitution, etc.) that kept their GDP growth in the green.
• There is the continuing Greek saga – will they stay in the monetary union or will they leave; and if they leave, will they repudiate their debt (probably); and if they repudiate, what implications will that have for European banks which hold most of that debt?
• Japan is in recession;
• Russia and other commodity based economies (mostly Emerging Markets) are struggling with large declines in commodity prices and are generally headed for recession;
• China reported a growth rate for 2014 of 7.4%, with the fourth quarter at 7.3%.  It is likely that real growth is much lower;
• To confuse things more in Europe, the Swiss central bank recently shocked the foreign exchange (FX) world by unexpectedly abandoning the franc/euro peg at 1.2 francs/euro.  The franc has risen 20%.  I suspect that some of the European banks, whose capital is already suspect, were negatively impacted.

     2. Falling Oil Prices Have Far Reaching Consequences

• Russia, Libya, Iran, Iraq, Saudi Arabia, Kuwait, the UAE, Venezuela… all oil exporting countries are seriously hurt by the plunge in oil prices;
• German banks have a large volume of loans to Russian companies; given conflicts with the west and the fall in the price of oil, there is some concern with rising prospects of default;
• There is the contention that U.S. job growth has been concentrated in the oil and gas producing states.  Here is the statistic I saw:  over the last seven years, the oil states produced 1.36 million jobs while the non-oil states lost 424 thousand jobs;
• Oil drilling plans have already declined by 20%, and it isn’t unusual to see a decline of 50% when oil prices tank.  The decline in drilling, it is said, will trickle down through the oil states’ economies killing more jobs than just those in the drilling business.

3.  Deflation is Approaching

• The fall in the price of oil along with nearly every commodity has signaled to some that a 1930s style deflation is approaching.  In that scenario, not only do commodity prices fall, but so do incomes, and , if the income fall is severe enough, there are significantly increased business liquidations, debt; and sharp reductions in asset prices (both real estate and equity).
• The strongly interconnected global markets and financial system will cast the deflation upon our shores and because of the huge global buildup of debt, deflation will be accompanied by massive debt liquidation and a sharp decline in U.S. GDP and the equity markets.

  4.  The Price of Gold

The rise in the price of gold in 2015 confirms all of this doom.

All of this sounds scary – and it would be if it were all true.  But, most of it is exaggerated.

1.  Global Conditions

• No doubt Europe, Japan, Russia and commodity producing countries are in or near recessions.  This, along with the strengthening dollar, will hurt the margins of some multinational corporations.  We’ve already seen some signs of this in the 4th quarter earnings reports.  But, historically, a strong dollar has been accompanied by rising PE multiples.  Thus, slower earnings growth is likely to be offset by the desire in the rest of the world to hold dollar denominated assets since their own currencies are depreciating.
• In addition, the U.S. economy is mainly closed with only 10%-12% of GDP coming from exports, while other trading partners show exports as high as 50% of GDP. So events in other economies are not likely to have much impact on the U.S. economy.

2.  Oil Jobs

The data on job creation in the oil producing states covers a 7 year period including the massive layoffs in the aftermath of the financial crisis.  But, if we look at the most recent data, the job story has a different hue.  The table below shows the top 10 oil producing states with the growth in their jobs for the past year (November is the latest data, so the numbers are November 2103 through November 2014).

The table attributes 75% of the employment growth to the oil industry in all of the states except California and Texas.  Given the growth in Silicon Valley and in the tech sector, and because the California economy is so diverse, I used a 20% factor there.  For Texas, I assigned a 60% factor, as there is other economic activity in that state besides oil.  So, even under these most generous assumptions, in 2014, approximately 500,000 new jobs can be attributed to the oil states (the real number is likely much lower).  There were almost 3 million new jobs created in 2014.  So, it is a long stretch to conclude that oil has been responsible for most of the jobs created.  Even if no new oil jobs are created (which is hard to believe because we in the U.S. will be using more oil, not less, as the price comes down), the U.S. still produced an estimated 2.5 million non-oil jobs last year.  The question to ask is:  Can the U.S. live with 200,000+ new jobs per month?

3.  Deflation

• Deflation is more than a commodity phenomenon.  Services in the U.S. represent about 80% of the GDP while the production of goods represents a much smaller share.  Inflation in the service sector has been running near 2.5% for the last couple of years, so the commodity deflation is not about to overwhelm the services inflation.
• The worry about the liquidation of the massive build-up of debt is also exaggerated, as almost all of the debt build-up is on the balance sheet of governments.  In the U.S., for example, the household sector has significantly de-levered since the financial crisis, and CFOs of corporations have borrowed long at very low rates, so that debt is a non-issue.  Except for the Eurozone where participating countries cannot print money, every other sovereign government can – so, if they need to print money, they will.  You might not get back what you gave them in purchasing power, but there won’t be a default.  And now the European Central Bank has announced the printing of €1.3 trillion over the next 21 months; this will go a long way to calm the Eurozone deflation fears (and the equity markets love it).
• There are two kinds of deflation – bad and good.  Bad occurs when demand falls because incomes are falling, which causes prices to fall and margins to be squeezed as companies vie to capture a share of a shrinking market.  Some of this is occurring in Japan, in some of the European countries, and in some emerging markets.  Good deflation occurs when demand is rising but supply is rising faster.  While the price of gasoline is falling, since demand is actually rising, there is no need for margins to be cut to sell the product.  While oil/gasoline is the main example, this is also true of other commodities as industrial production in the U.S. is on an upward trend line.
• Unless there is a large and significant exogenous shock (major terrorist attack, crippling cyber attack, rapidly spreading untreatable disease (like ebola)), deflation is not coming to the U.S. anytime soon.  Even if it began, what do you think would be the reaction of the Fed?  More QE for sure (and the markets love QE!).

4.  Gold

The price of gold is likely rising because all of the central banks (except India) have adopted the new monetary policy paradigm, print first, ask questions later.  Gold, after all, is priced in currency terms, and if every major currency is depreciating, the price of gold, in terms of those currencies, has to rise.  In terms of dollars, because it is rising in value relative to other currencies, gold’s price appreciation in dollar terms will be less than its appreciation in terms of other currencies.

Conclusions Regarding Deflation

None of this means that equity prices can’t go down.  But they usually don’t stay down for long without a significant recession.  Underlying economic conditions in the U.S. are healthy; there is no recession in sight.  There certainly are things to worry about, maybe more so now than normal as there is a lot of political instability in the world too.  But, if the economy stays strong and there is no significant exogenous shock, it is normal for markets to perform well.  In addition, the entry into the QE fray by the European Central Bank will likely quell the Eurozone deflation worries, at least for awhile.

Rapid Decline in Interest Rates

I do have some worries.  My biggest concern is the rapid decline in the mid- and long-term yield curves, both here and abroad.  While below I rationally explain why this is happening, this concerns me because the bond market has historically been the most reliable indicator we have had regarding economic growth.  Low and falling rates are historically associated with weak economic growth.  If the Fed actually resorts to raising short-term interest rates in 2015, we could end up with an inverted yield curve; every post-WWII recession was preceded by an inverted yield curve.  The Fed should wait for the rest of the world to show economic growth, and for foreign central bank QE to stop, before embarking on “normalizing” monetary policy.

Now for the rational explanation:  The new paradigm of central banking is money printing, and we have had a ton of it.  At the same time, the regulatory regime in the financial world has tightened up considerably.  But regulatory policy looks favorably on holdings of sovereign debt.  In 2014, the U.S. Treasury issued net new debt of about $630 billion (the federal budget deficit).  In 2014, foreign central banks purchased about $400 billion of U.S. Treasuries, the Fed, itself, absorbed about $250 billion, and U.S. banks added about $160 billion to their balance sheets (due to new regulations).  In addition, it is estimated that U.S. pension funds added significant volumes of Treasury debt to their balance sheets to de-risk (i.e., liability matching).  So far, this totals more than $1,000 billion (i.e. $1 trillion) and does not count the demand from sovereign wealth funds, other institutions, or individuals.  So, it isn’t any wonder that the U.S. Treasury yield curve has flattened.  When we look around and realize that the European Central Bank is about to embark on its own QE program (€1.3 trillion), that Japan is continuing its QE program, and that China may join the fray to weaken its own currency, it seems reasonable that interest rates will continue downward.  We have entered an era of mercantilism (i.e., currency wars).   Maybe, for once, this time is truly different, and the flattening yield curve doesn’t presage an oncoming U.S. recession.

To continue the story, the money that is created by these central banks is deployed in the foreign exchange market (FX) which converts the newly printed stuff into dollars in order to cheapen that central bank’s currency relative to the dollar.  The dollars that are purchased in the FX market come from the pool of dollar IOUs generated by the U.S. trade deficits these past 5 decades, which pool now serves as the world’s “reserve currency” to lubricate trade between nations.  90% of all trade in the world today is done in dollars.  But, when the central banks use these newly acquired dollars to purchase U.S. Treasuries from the New York dealers, those dollars are repatriated into the U.S. economy, just as if the Fed had created them in a QE operation.  The new liquidity eventually finds its way into the equites arena.

I suspect all of this will end sometime. But I don’t see that happening anytime soon.  After all, the Fed and its ilk will now resort to massive money printing anytime a “recession” approaches.  This policy contributes greatly to the growing income gap between the rich and the middle class, because the new money finds its way into the financial markets.  Maybe that is where it ends, but I highly doubt it.