The market's correction has many scratching their heads

In “The Tipping Point,” Malcolm Gladwell tries to describe the evolution of modest notions to megatrends. How and when does the accumulation of small impressions come to change larger perceptions? What makes for that dramatic moment when everything seems to change all at once? While Gladwell offers some clues on how these transitions come about, they remain a matter of some mystery.

From one perspective, the market movements of the past two weeks are based on an understandable accumulation of impressions. Economic performance across the world is very uneven: the United States and the United Kingdom are doing well while China transitions to slower growth and Europe struggles. Geopolitical uncertainty surrounding Russia and the Middle East is a source of concern. Central banks have been challenged to set appropriate policy, creating uncertainty for investors.

But from another perspective, the corrections and volatility we’ve witnessed recently are somewhat mysterious. None of the factors noted above are new; they’ve all been discussed at some length for many months. Until two weeks ago, markets seemed to acknowledge and accept the risks to the outlook, choosing nonetheless to focus on its many positive aspects.



If there is a tipping point for the market’s retreat, it might be the minutes of the September Federal Open Market Committee meeting, which were released on October 8. The narrative reflected a heightened sense of concern about global risks; some may have taken this citation as an indication that policy-makers had grown darker on the outlook.

Viewed through a darker lens, all incoming news seemed to suggest the worst. A single month’s decline in retail sales was taken as a major warning sign, while robust year-over-year spending gains were ignored. Falling energy prices were seen as reflecting economic weakness, not as a boost to consumers in advance of the holidays. In the minds of the markets, Mario Draghi’s effort to revive the eurozone economy is now depicted as futile, not fruitful. Ebola morphed from an isolated pathogen to something which might be broadly contagious to commerce.

Associated with this wholesale re-evaluation of economic prospects was a significant shift in expectations for the Federal Reserve. This is a surprising development, given the dearth of economic data received since its last meeting. And among the data we have received is a very strong employment report.



The abrupt change of psychology made for a dizzying decline. Computer trading was blamed for making the problem worse: there was a “flash crash” in the market for 10-year U.S. Treasury bonds on Wednesday morning. Yields collapsed by 15 basis points in less than five minutes, only to regain most of that distance in the next five. Others cited the lack of liquidity in markets (discussed in our July 25 commentary) as another impediment to stability.

There were certainly some technical things going on, but one ignores market signals at one’s own peril. It could well be that asset values were a bit stretched relative to fundamentals and needed to be reset, but I’ll leave it to my partners in our Asset Management group to comment on that. Fundamentally, here is our take on things.

• We do not anticipate making any changes to our forecasts unless the correction persists and creates a feedback loop on economic activity. It is worth noting that equity values are still considerably higher than they were two, three and four years ago. Much of the wealth created remains in place and serves as a strong backdrop for spending and credit. The sheer momentum of job creation is also a powerful tailwind for the United States.
  
  
• One Fed president came out this week with a call to extend quantitative easing, but we think it is premature to contemplate a change of strategy. Our call on the timing of an initial interest rate increase has not wavered for some time: September 2015 remains our most-likely case. Falling inflation, perhaps more than labor market slack, will support accommodation for some time to come.
  
  
• We will continue to watch the eurozone closely. Results of the European Central Bank’s bank asset quality review (AQR) will be released on October 26, and we’ll analyze them carefully. Our international team will also focus on the European Commission’s debate over the French and Italian budgets and the evolving posture of Germany toward economic stimulus.

Being an economist at times like this is frustrating. Clients become more anxious for answers at the same time that standard modes of analysis are less useful. The best tonic for all would be swift stabilization and (dare we say it?) a rapid restoration of lost value. If the rout continues, though, I might contemplate a long vacation.

The Russian Bear Market

Among the geopolitical uncertainties cited as contributing to the recent market correction, Russia’s aggression in Ukraine stands toward the top of the list. Ben Trinder, our analyst following the situation, reports.

Over the past couple of months, the Russian ruble has been in free-fall. The currency recently traded above 40 to the U.S. dollar for the first time, prompting central bank intervention, a shift in the targeted trading corridor and fears of capital controls. The last time Russia was under this much market pressure was 1998, an era which resulted in a sovereign debt default.

This begs the question: will history repeat? How long can Russia survive the ongoing standoff with Ukraine and its associated repercussions before it is in real financial distress? The answer: quite a while. For while there are some modest similarities between today’s conditions and those of 15 years ago, differences dominate.

A quick re-cap of what happened in the late ‘90s helps provide perspective. After the breakup of the Soviet Union, Russia became saddled with huge debts from the former USSR. At the same time, the economy was transitioning from the communist era to that of a free market. Tax collection was weak, government revenue was low and the price of Russia’s main export (oil) was falling, forcing the current and fiscal accounts into deficit.

Toward the end of 1997, the Asian crisis erupted, prompting a speculative attack on the ruble. The Central Bank of Russia (CBR) defended its currency by using its foreign reserves to intervene in markets; 23% of total reserves were spent in the last quarter of 1997 alone. Interest rates were hiked to 150% in June 1998 in an attempt to stem capital outflows.

Unfortunately, investors were spooked beyond the point of reassurance. By August 1998, the Moscow Exchange (MICEX) stock index had lost more than 70% of its value. Investors realized Russia’s fundamentals were poor and believed a devaluation of the ruble and default was imminent. By mid-August 1998, both events had come to pass.

There are some parallels between today’s situation and that of 16 years ago, but many more important distinctions. Vladimir Putin’s incursions into Ukraine have led to a civil war in that country, and Western sanctions against Russian corporates were imposed as punishment. This has had the same effect of shifting investor sentiment as the Asian Crisis did. Capital has been heading out of the economy; worryingly, the exodus includes many domestic investors who have lost confidence in their own country.



The CBR has once again been utilizing its reserves to support the ruble; they are down US$60 billion so far this year. But Russian reserves, buoyed by massive oil revenues, are 57 times bigger now than they were during the previous crisis. There is plenty of dry powder at hand.

The fall in Russian stock prices has been much less pronounced than it was in 1998; the MICEX is down just 7.8% down year-to-date at this writing. The CBR has raised the one- week repo rate twice this year – to 7.5% in April and then to 8% in July – to help steady inflationary pressures (a by-product of the falling currency). This is a far cry from the 1998 experience.

So it appears that Putin and friends have the depth to hold out for some time. The hardest question is where will the crisis go from here? The falling oil price adds another twist to the story. The new budget assumed a price of more than $100 per barrel, and with the price currently below $90, revisions to spending in the coming months are highly likely. Should pressure start building on the budget, sentiment toward Russia could rapidly sour further. Therefore, if oil prices remain low for an extended period, we may see a quicker Russian pullback than previously expected.

Ultimately, though, it’s very unlikely Russia will experience a crisis of the same magnitude seen at the end of the last century. Interestingly, Russia’s current challenge stems from trying to rebuild the same Soviet spirit whose demise created such problems not long ago. That is an irony that Tolstoy would have appreciated.

The U.S. Federal Budget Deficit: Healthier but Not Healthy

The federal government’s 2014 fiscal year ended September 30, and it brought good news: the federal budget deficit is significantly smaller compared with 2013. Although this is a legitimate reason for celebration, we should be mindful of the durability of this improvement and recognize that long-term challenges remain unresolved.

The U.S. federal budget deficit declined to $483 billion in fiscal year 2014, down $197 billion from the gap registered in fiscal year 2013 and the smallest deficit in six years. The budget deficit is 2.8% of gross domestic product (GDP), which is meaningfully smaller than the 10.2% mark of 2009.

The Congressional Budget Office (CBO) estimates that the budget deficit is likely to shrink slightly in 2015 but widen thereafter in absolute terms and begin to climb again as a percentage of GDP from 2019. Consequently, publicly held debt is estimated to touch nearly 80% of GDP by 2024.



The nearly steady federal budget deficit as a percent of GDP in the next few years is a welcome development, as it implies reduced pressure on interest rates as the Federal Reserve contemplates normalizing monetary policy.

Long-term implications of a persistent and widening deficit are the central concern. An extended period of deficits and growing national debt eventually reduces private-sector investment and erodes productivity and the nation’s standard of living.

This gloomy prognosis is preventable only if federal government expenditures are contained in the future. Of the major components of government outlays, health care spending is the largest and fastest-growing item. There is encouraging news on the health care front. Growth of health care costs stabilized in the last few years after exceeding inflation by a large margin for an extended period. The key question is what factors brought about the decline in Medicare costs and whether it is sustainable.

Containing health care costs is critical to putting the federal budget on a sustainable path. Some combination of natural forces and legislation will be needed to achieve this outcome.

Speaking of legislation, the upcoming election on November 4 may shift control of the Senate, but we will continue to have a divided government. At times in the past, power- sharing has paved the way to compromise, but few are expecting much legislative movement next year.

Pulling the strands together, it has been well-known for several years that the federal budget’s trajectory is unfavorable and short-term Band-Aids are inadequate. It remains to be seen if the new Congress will take this opportunity to address the challenge while there is room to navigate.