During this phase we have seen wild swings that seem to come from nowhere, pushing the market significantly higher or lower, often on the same day.
It is obvious by now that the nature of the financial markets has changed dramatically from a year ago. Back then; expectations were for yet another strong stock market bolstered by a strong and growing economy. The picture is different today. While the FED Chairman may be waffling regarding the state of the economy, consumer spending, industrial production and transportation measures indicate that growth has slowed dramatically or stopped. The investor world is unclear about future direction.
While a period like this is not unusual, it does conjure up fears of the big economic and financial crashes in our not-so-distant memories. We can see some red flags, but it should not be taken as a certainty that we are headed for recession or a notable market crash.
When markets get crazy, we humans tend to behave badly. Right now investors are afraid, and maybe with good reason. We feel that we must act, and without clear facts we tend to act on emotion. Research has shown time and again that these emotional reactions tend to be detrimental to wealth preservation. It is now when discipline and patience are important. At Calyx our process rules are insulating us from the recent market declines and we continue to evaluate market signals and act accordingly.
Everyone has been touched by the relentless decline in oil prices. Here in the US, gasoline at the pump is less than half of what it was a year ago. The chart below illustrates the decline in oil since the beginning of 2015, dropping from $75 a barrel to $30 a barrel.
The drop in the price of oil has created a series of very interesting financial, political, and social dilemmas. Global oil production has continued at the same pace as before the price drop. Only 0.1% of global oil production has been curtailed due to the price slump over the last 18 months. Oil producing countries have failed to agree to slow production to stabilize prices for fear of losing market share. No one has stopped pumping.
There has been some pain, though. The foreign exchange reserves of Saudi Arabia, Russia and other producer nations are dropping substantially, as their oil revenues fall short of their domestic needs. The petrodollar sovereign wealth funds of most of the world’s oil producing countries have lost several $ Trillion in value, impacting the world equity markets as sovereign wealth funds have liquidated parts of their portfolios.
All this excess oil has been diverted to storage where capacity still seems to grow. The question many are asking is which will come first: Will consumer nations run out of storage or will producer nations run out of foreign exchange reserves?
Unfortunately, the real oil war may now just be starting in the Middle East. Domestic unrest and/or attempts to disrupt competing nations exporting capability could turn ugly and the world needs oil to continue flowing out of the Gulf. Americans have been told that we are achieving oil independence, but the truth is we still import more than 50% of our oil. Any disruptions in the Gulf would be felt in higher gas prices very quickly. Meanwhile in the energy sector, no one has gone bankrupt. Companies have enacted cost cutting, and in a few cases dividends have been reduced, but overall energy companies are hanging on, for the moment.
The knock on effect of this has been a few scares in the credit markets as the bonds of some companies and oil producing nations have come under scrutiny and their bonds have become influenced by oil. Similarly, during the last 6 weeks this link with oil has caused incredible price swings as world equity markets mimicked the price of oil. Each day we have seen the equity markets attempt to decouple from oil, only to be drawn back to the most recent oil price move.
Since the financial crisis of 2008/2009, the Federal Reserve Bank has pursued a policy of lower interest rates to aid the economic recovery. Their belief has been that lower interest rates would stimulate employment and spending. The Fed printed money, buying securities with freshly minted dollars to push interest rates down to near zero.
The expected result to this expansion of money in circulation (the monetary base) was a recovery in our economy. Instead the sum of goods and services (GDP or Gross Domestic Product) from 2010 to the present has declined. During the same period we witnessed a powerful rally in the stock market. Fueled by cheap money, share prices rose in every sector. Investors cared less about good strong companies than in quick growth stories using cheap money to invest.
The three charts below tell the story. On the left side, the top picture shows the expansion in the US monetary base from $1 to $4 trillion. As interest rates dropped to zero, lending should have powered GDP higher. Instead, the bottom chart shows that GDP growth DECLINED in this period, not increased.
The chart on right shows how the growth of the FED balance sheet, the supply of money in circulation, correlates directly with the stock market. It also shows the end of the Fed’s stimulus program in early 2015 is now correlating to the flattening and volatility of the stock market in 2015, and the correction we have seen so far in 2016.
Right now investors are wondering whether the Fed strategy that has been in place for several years is actually working to bring about a recovery, or has created an artificial condition where markets are un-coupling from reality. The actions of the FED and the other central banks may have caused market reactions that have misled and confused investors.
During the last several years, China has been a big part of the world economic recovery. With its move toward a more market oriented domestic economy, cheap labor, and a nearly insatiable appetite for commodities, China has achieved incredible economic growth and has become one of the world’s largest economies.
China has been a huge importer of energy and raw materials to build internal infrastructure for itself and exported goods for the west. But starting in early 2015 China’s steep growth curve began to level off. Rising wages and slowing demand for exported goods led to a decrease in Chinese energy consumption just as Western oil production using fracking technology began to surge. Similarly, world commodity prices began to decline as China retreated from those markets.
The ascent of China’s economy was aided by an aggressive export friendly currency. The undervalued Chinese Yuan helped China’s growth by making its exports relatively cheap on world markets, using foreign exchange to help finance its growth. But anxious to be recognized as one of the world’s dominant players, China petitioned the World Bank to have the Yuan recognized as a reserve currency, on the same footing as the dollar and the euro. This recognition introduced China to the world’s foreign exchange markets, where capital flows from one currency to another in search of yield and value.
The Chinese central bank, seeking to stimulate their economy with increased exports surprised the world foreign exchange markets, announced a program to gradually reduce the Yuan’s value. Their aim was to control the Yuan’s value to China’s benefit, as they had successfully done in the past. The strategy backfired.
Foreign exchange traders saw the opportunity and aggressively sold the yuan against dollars, euros, and yen, quickly creating a massive sell off on the world markets. China was forced to support its currency by selling its dollar reserves to buy back yuan, quickly burning through almost $99 Billion in January alone. Estimates are that China’s reserves are nearing a three year low in their ongoing efforts to support its currency.
Ultimately, a revalued yuan will help China’s exports and contribute to its stabilization.
Looking back on the last few years, we believe we are in the late growth stages of the economic cycle. While there are some market watchers who think that we are beginning a recession, the weight of the evidence is that we are not. Late stages can last 3 months or 3 years.
The Fed should remain on track to slowly normalize interest rates. Unless stock market volatility forces the central bank to lose its nerve, we expect the Fed to stick with its plan to gradually increase rates, even if “gradual” takes longer than a few quarters. It is important to get the economy back to a normal situation in lending rates.
The current situation in the Oil market will take some time to play out, and we need to be open to the possibility that things will get worse. Overall it is likely that oil prices will recover in time, and we could even see price spikes if there are supply disruptions.
China is an enormous economy that will continue to grow, although at a more subdued pace than previously. China accomplished in 20 years much of what America did in more than a century, building an industrial economy and cities with modern transportation systems. But just as Japan’s growth in the 1970’s flattened in the 1990’s, China’s has slowed for many of the same reasons. This slowed growth is having repercussions that affect the rest of the World.
For investors, this is not the time to focus on growth, but instead to focus on protection and look for income and opportunities. The easy returns of 2013 & 2014 gave way to the losses of 2015 as all the asset classes realigned. These periods move slowly – in months and quarters, not in days or weeks. So, paying attention to the daily news and stock quotes is not helpful (a study has found that people using cell phones for investing news and trading do worse than others, they act on “gut” and emotion, which is notoriously wrong). What is most important is waiting for the trend to clarify. Hype is in the best interest of the news media but is harmful to the rest of us.
So is it time for Oil? High-yield bonds? Emerging markets? While we have been writing this note the stock market has traded back and forth twice across a 250-point range. This is not a time to take a lot of risk. Treasuries are a better bet than Junk. People are going to safety now. Patience is the best investment.
God bless you,
Ed & Branson
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