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By HaleStewart October 3, 2014 11:53 am
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International Week in Review: The Sky Is Not Falling, But the Calculus Has Changed

     Although they comprise a small percentage of most leading indexes for developed countries, the equity markets take a more pronounced place in news reports when they sell-off.  And over the last week, reports have focused on several aspects of stock performance including the degree of the sell-off in various indexes and news of several averages approaching key support areas.  At times like this, gloom and doom commentary begins to take center stage as “sky is falling” headlines become click bait for various websites.  Unfortunately for the bearish crowd a careful analysis indicates we are not near a major, cataclysmic market or economic event.  However, it is clear that the underlying calculus regarding macro-economic analysis has changed, caused by a combination of increased geopolitical conflict, potentially higher interest rates in the US and UK and the ripple effects from this development, and growing economic concern regarding the EU, Japan and, to a lesser extent Australia.

     Until about a year ago, it seemed as though world events were at least relatively stable.  But over the last 12 months increased global tensions in a variety of locations have developed.  It started in the Ukraine, as separatist troops (with Russian support) first annexed the Crimean Peninsula (and its accompanying offshore natural resources) and then worked to destabilize the country’s eastern region.  Several months ago events came to a head with the downing of a commercial airliner.  Despite a recent cease fire, the conflict has recently increased in intensity.  Problems have also emerged in the Middle East along two fronts.  Israel and the Palestinians had a brief but bloody conflict.  And there is the advance of ISIS in Syria and Iraq, destabilizing an already tense region.  Despite a slow response, an international coalition is again in place attempting to slow down the group’s advance primarily through the use of airpower.  Military analysts and advisers, however, continue to argue that “boots on the ground” are unavoidable.  And, as if we didn’t have enough to concern us, we now have democratic demands developing in Hong Kong and the Ebola outbreak in West Africa.  The total effect of these events is to once again remind investors that political stability is not a given.

     Adding to the economic tension is the potential effect of the “taper tantrum” caused by increasing interest rates in the US and, to a lesser extent the UK (although it’s far more likely for the UK to start raising rates before the US).  To understand the impact of this event, let’s look at what happened when the Fed and other developed countries cut their interest rates to near 0%.  As developed country rates moved lower, investors sought out higher yielding assets.  This led to traders buying assets in emerging economies, leading to an increase in developing market currencies and markets (You may recall during this time that some countries such as Brazil argued the US was engaging in a “currency war”).  As the potential for increased interest rates increases, the reverse happens; money leaves developing economies and heads back to developed countries.  This leads to a drop in emerging market currencies and equity indexes.  The former increases inflationary pressures, forcing central banks in Brazil and India to raise rates, slowing their respective growth.  And the latter simply lowers overall investor confidence.  But the net effect of this development is to increase financial instability. 

     And adding to the rising level of uncertainly are the economic developments in the EU, Japan and to a lesser extent, Australia.  Regarding the EU, Mario Draghi’s recent analysis from his policy announcement provides an excellent overview:

Let me now explain our assessment in greater detail, starting with the economic analysis. Following four quarters of moderate expansion, euro area real GDP remained unchanged between the first and second quarter of this year. Survey data available up to September confirm the weakening in the euro area’s growth momentum, while remaining consistent with a modest economic expansion in the second half of the year. Looking ahead to 2015, the outlook for a moderate recovery in the euro area remains in place, but the main factors and assumptions shaping this assessment need to be monitored closely. Domestic demand should be supported by our monetary policy measures, the ongoing improvements in financial conditions, the progress made in fiscal consolidation and structural reforms, and lower energy prices supporting real disposable income. Furthermore, demand for exports should benefit from the global recovery. At the same time, the recovery is likely to continue to be dampened by high unemployment, sizeable unutilised capacity, continued negative bank loan growth to the private sector, and the necessary balance sheet adjustments in the public and private sectors.

The risks surrounding the economic outlook for the euro area remain on the downside. In particular, the recent weakening in the euro area’s growth momentum, alongside heightened geopolitical risks, could dampen confidence and, in particular, private investment. In addition, insufficient progress in structural reforms in euro area countries constitutes a key downward risk to the economic outlook.

According to Eurostat’s flash estimate, euro area annual HICP inflation was 0.3% in September 2014, after 0.4% in August. Compared with the previous month, this reflects a stronger decline in energy prices and somewhat lower price increases in most other components of the HICP. On the basis of current information, annual HICP inflation is expected to remain at low levels over the coming months, before increasing gradually during 2015 and 2016.

Although his statements contain a fair amount of favorable projection (“we’ll see growth soon”), it’s becoming more and more difficult to believe this is possible.  Unemployment stands at 11.5%, inflation continues to move lower on a year over year basis, loan growth remains negative, industrial production is lackluster and sentiment continues to move lower.  There is simply no good news emerging from this region of the world right now.

     The news from Japan is adding to the concern.  Abenomics – the economic plan of Prime Minister Abe – was premised on three “arrows:” a massive increase in the currency base to lower the yen’s value, leading to an increase in exports and inflation; fiscal stimulus and structural reforms.  The BOJ has performed the currency debasement.  But while this has had the desired inflationary impact, it hasn’t led to the desired increase in exports because most Japanese companies have moved their production offshore.  And the inflationary increases are beginning to slow.  Fiscal stimulus has been present, but structural reform has been slow in coming.  Compounding the problem was the massive 2Q GDP contraction of over 7%, caused by a slight sales tax increase that pulled sales forward into the first quarter.  While employment remains strong, it hasn’t translated into rising wages.  And industrial production has been in a solid downtrend since the first of the year.  Overall, Abe gets an “A” for effort, but the general trend of his economy is still sketchy.

     And recent news from Australia is starting to raise concerns.  Although the country is clearly still growing at decent rates, more and commentary about a potential housing bubble is emerging.  The domestic housing market is probably keeping the RBA from lowering rates from their developed world high 2.5% level.  Unemployment has been ticking higher.  Although the latest reading showed a decrease from 6.4% to 6.1%, most commentators felt this was simply not possible, instead attributing the decline to statistical problems.  And business sentiment has been reading in contractionary territory for the last year as executives try to discern the economy’s direction in the wake of China’s slowdown (and the accompanying declining natural resource appetite).  Although the country is clearly not in a recession, the economic numbers are showing increasing stress.

     Turning to the effect of these events on global investment flows, there are several trends currently in place.  The first is a “run from risk trade” which is leading to lower equity prices and higher government bond prices (and lower yields).  This is hitting global equity indexes, not just the US.  Adding to the downward equity pressure is the high valuation levels of most developed stock markets.  For example, by most traditional valuation models (price to earnings, price to book) the US market is pricey.  A secondary trend is the run-up in the dollar which is happening as investors seek out US government bonds (the US is seen as a safe haven) .  Compounding this movement is the run from the euro trade, which is happening as the ECB moves into a looser policy stance.  There are also decreasing commodity prices, caused by a combination of over-supply (agricultural goods) and decreased overall demand (the Chinese slowdown).  The dollar’s recent bull-run has exacerbated this trend. 

     All of these recent moves stand in stark contrast to the prevalent investing sentiment of the last few years during which equity markets received massive inflows seeking out higher returns and the euro rallied under Draghi’s “whatever it takes pledge.”  And it is that change in direction that is confusing investors right now.  While the confusion is natural, it is to be expected as a result of the changing international calculus caused by the above-mentioned events.  And no, the sky is not falling. 

         Hale Stewart is a former bond broker who has been writing about economics and financial markets since 2006 on the Bonddad Blog.  He is also a tax attorney with a domestic and international practice while also forming and managing captive insurance companies for US companies.   You can follow him on twitter at:@captivelawyer





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