Financial markets in 2015 were pulled between the Fed’s determination to raise rates as the U.S. job market strengthened and pressure for lower rates in the rest of the world as China’s economic growth slowed and commodity prices sank. The results of this tug of war were a soaring dollar, crumbling junk bonds, low Treasury yields and a manic-depressive stock market that ended the year roughly where it started. Last quarter, my opening paragraph stated, “The U.S. has enjoyed a good six year run in asset prices….The fear is that the Bears may have recently come home.” Similar tensions will continue into the start 2016.
We are focused on several global themes of shifting cycles, steps forward and back, bearish tendencies, and China’s economic adjustment that will affect investors and expose vulnerabilities.
- I. Shifting economic cycles – The Fed wants the monetary policy cycle that has dominated financial markets for years to take a back seat to other cycles for the first time since the financial crisis; thus, the Fed took a first step towards raising interest rates by ¼ percent in December. [Note: Just like taking training wheels off a bike, the Fed’s decision to raise rates is not necessarily the wrong long-term decision, but the near-term consequences could be quite painful.] As the Fed induced liquidity wave crests, Chairman Janet Yellen would like the natural forces of capitalism to take over the economy and propel growth. However,
- The business, credit and valuation cycles which should now gain in importance, are out of sync; and
- It is questionable whether normal capitalism will work well out of the gate after so much central bank intrusion
Expect subdued global growth with downside risks from emerging markets (EM), low-flation, and the U.S. Fed’s desire to hike rates.
- II. Deflationary boom – Deflationary boom is a waltz of forward and backward economic steps.
- Deflation refers to the step-down in demand in China, EMs and commodity producers that has led to low oil and commodity prices and high unemployment; deflation is an indicator of poor growth and makes debt more expensive to repay. [Note: There happens to be a lot more global debt today than there was before the last financial crisis.]
- Boom describes the step-up in household spending in the US, the euro zone and Britain, from lower oil and commodity prices and improved wages.
Thus, deflationary boom symbolizes investors lurching between the globally positive and negative aspects of this situation.
- III. We may be in a bear movement – Equity trends are negative (prices are declining), bond spreads are widening (which is a sign of weakness), and conditional elements continue to deteriorate. These factors cumulatively indicate persistent asset price weakness and deteriorating corporate balance sheets. The good asset price returns we’ve seen since the financial crisis borrowed performance from the future; prices are adjusting.
- IV. China, the other superpower – The International Monetary Fund (IMF) recently added China’s yuan to its basket of reserve currencies (which are each expected to be relatively free-floating); however, the yuan, which traditionally has been tightly controlled by China is 10% to 15% overvalued. If Beijing sticks to a reform path and controls the yuan’s depreciation through freeing capital flows and letting the market determine its exchange rate, there is a chance – after a few years of economic and financial distress in China – that it can reinvigorate the global economy. But, if China fumbles and triggers a new currency war by letting the yuan fall sharply, exporting more deflation in the process – overcapacity, zombie companies, and currency devaluation would drive deflation – the world economy could tumble into a new recession and financial crisis; simultaneously, a soaring U.S. dollar will transfer pain onto the U.S. Considering the recent hiccups and Band-Aid fixes in China’s yuan, stock, and bond markets, investors are concerned about how Chinese officials will manage its currency.
The cumulative coincident effects of the Fed shifting towards higher rates, low commodity prices, active deflationary forces, and China’s yuan adjustment might not force the U.S. nor the world into recession, but they are definitely forcing the world to adjust return expectations.
Michael Ashley Schulman, CFA
Hollencrest Capital Management