Markets remain exceedingly volatile in this third week of the new year. Investors are jittery, and justifiably so given the historic magnitude of the declines to start the year. Market corrections are always upsetting. You can think you’re prepared, but enduring the carnage as it’s happening is always painful. Our best advice during these trying times is to resist the urge to think in extremes. There will be pundits in the media telling you just how bad things could get, but their prognostications almost never materialize. In March 1999, the cover of The Economist read “Drowning in Oil”, which was a reference to the oversupplied condition of the energy markets. Nobody was willing to take a bullish stance on black gold. But if we take a look at the historical chart of oil prices, the article coincided almost perfectly with the bottoming in the price of oil. Over the next couple of years, the price nearly doubled to nearly $38 per barrel before pulling back and ultimately heading to a peak of over $145 per barrel in July, 2008. In March of 2008, prior to that July peak, an energy analyst at Goldman Sachs raised his target price for oil to $200 per barrel. Of course, we all know that his prognostication never materialized. Instead, oil crashed from the July 2008 peak of over $145 to as low as $31.41 in December of that same year.
So, just as we have been cautioning against excessive “exuberance” for the past couple of years, we now caution against excessive pessimism. The markets and the economy undoubtedly have their challenges, but most predictions calling for the end of the world fall somewhat short. Maintain your composure, and remember that the last thing you should forget is the value of being a contrarian. Warren Buffett tells us to “be fearful when others are greedy and greedy when others are fearful”. I wholeheartedly agree.
For today’s Market Commentary, I thought I would share an excerpt from this quarter’s edition of The Farr View, which makes an attempt to explain some of the recent volatility.
Despite significant quarterly volatility, the US economy continues to grow at a pace consistent with its post-recession average of about 2.0%-2.5%. That pace of growth, while modest considering the depth of the recession, has been heavily dependent on ultra-low interest rates. Low rates have bolstered spending on housing, home improvements, commercial real estate, autos, appliances, college tuition, health care and just about anything else that is generally purchased on credit.
Unfortunately, though, the Fed’s aggressiveness in its efforts to “prime the economic pump” through low interest rates has been ill-conceived. Rather than allowing the process of deleveraging to run its course, low interest rates have simply encouraged the assumption of more debt as a solution to the problem of too much debt. In addition, low rates have pulled forward demand for goods and services that are purchased primarily on credit. So, as a consequence of the Fed’s actions, the potential for an acceleration in economic growth over the next few years seems rather limited. And this says nothing about possible fallout resulting from the creation of new assets bubbles.
Something you’ve probably heard us repeat several times by now is that the economy is not strong enough to withstand meaningfully higher interest rates. Over six years into the recovery, that contention remains valid. Smart people can debate about the cadence of Fed rate hikes to come, but the reality is that any meaningful monetary tightening at this stage is likely to thrust us back into recession. Higher interest rates will not only raise the cost of servicing a mountain of debt, both public and private, but it could also exacerbate the recent gains in the US dollar. Further increases in the dollar would continue to eat into exports, which account for well over a strengthening dollar could exacerbate recent disinflationary pressures at a time when the Fed would like to see more inflation. And then there’s the problem of China.
If the volatility and uncertainty in 2015 revolved around the Fed, China is likely to grab the headlines in 2016. To be sure, China’s direct effect on the US economy is very small. Exports comprise about 13% of US GDP, and only about 8% of our merchandise exports go to China. Therefore, our economy’s direct exposure to China is limited to just about 1%. However, a dramatic slowing in the Chinese economy, which is the second largest in the world, can have many ancillary effects on the US and global economies:
- Exports to China comprise a much bigger portion of GDP for many of China’s other trade partners, including Japan, Europe and many developing markets that are heavily dependent on natural resources. Trade-related economic weakness in these economies could have a negative impact on US economic growth through lower exports, profits and employment at US multinational corporations. China’s recent currency devaluations magnify the pressures on its trading partners.
- China is the largest holder of US Treasury securities with about one-fifth of total US debt held by foreign countries. Any liquidation of its holdings of about $1.3 trillion (to spend on stabilizing the economy through fiscal stimulus, for instance) could lead to higher interest rates in the US.
- China’s growth deceleration has contributed to a devastating crash in commodity prices, especially energy. Now that the growth boom has subsided, there is a huge amount of overcapacity in many commodity markets. Producers of energy and other commodities in the US are not immune.
- The growth in Chinese infrastructure, triggered in response to the financial crisis, was funded with huge amounts of public debt. Now that the construction boom has effectively ended, the slowdown in China creates the risk of another financial crisis resulting from huge amounts of debt accumulated in that country as well as in other emerging markets.
- Turmoil in emerging-market stocks and bonds could lead to investment losses in the US, which could spread to other markets and create a negative wealth effect.
The Energy Sector
The problems in the Energy sector are well documented and understood at this point. First, notwithstanding the Fed’s optimism for the US, global economic growth is weak and may be getting weaker, and the sluggishness is not confined to China. Europe and Japan remain weak, and the Emerging Markets (ex China) are suffering from massive capital outflows due to economic stagnation, overinvestment, falling currency values, and their heavy dependence on the commodity markets. Meanwhile, the variance in economic growth between the US and the rest of the world is contributing to strength in the US dollar, which further pressures commodity prices in the global marketplace.
But the collapse in the energy prices is not solely due to sagging demand. As mentioned, the sector is also suffering from the aftereffects of a supply-side shock, itself the result of many years of easy money. During the past 6-plus years of ultra-loose monetary policy in the US and beyond, credit has been cheap and abundant as investors frantically sought acceptable returns on their money. The easy money led to massive investments in energy exploration and production, which created a global boom in the industry. The biggest production gains, though, came in the US where new technologies like horizontal drilling and hydraulic fracturing created an energy renaissance not unlike the 1990s boom in Silicon Valley. The widespread adoption of these new drilling techniques was made possible by easy access to cheap credit. The result – a massive increase in the supply of energy.
Again, the problems now surfacing in the Energy sector are the direct result of ultra-loose monetary policy. But the pain that energy investors are now experiencing is all too familiar. For the past 20+ years the Fed has repeatedly propagated these boom-bust cycles that always end in severe pain for speculators. Whether it be the technology, housing, the energy complex, high-yield bonds, or stocks, the Fed’s largesse has consistently put us in these predicaments. Fortunately, stocks are not in bubble territory this time around, and valuations have already come down quite a bit.