Takeaways: Markets didn’t know quite how to react when the Fed held last week. That’s hardly surprising when messages shift, narratives conflict and seven years of abnormal policy has created a ‘misallocation of capital’. A breakdown in the ‘normal’ relationships between assets and responses to good and bad news is becoming par for the course.
Nevertheless, this week’s blog attempts to unpick the repercussions from the muddle of responses. It feels increasingly like ‘hold’ might be the theme into 2016 – on both sides of the Atlantic – in an increasingly weakening context. Defaults remain low, but growth also remains subdued and the longer this lasts, the more likely we’ll see significant capital transformation in sectors at the coal-face of the ‘new normal’ – like oil.
Emergers back on Fed agenda
In February 2014, Janet Yellen made it clear that the Federal Reserve set interest rates for the US and it wouldn’t change its course unless emerging markets posed a systemic threat to the US economic outlook…
…and here we are.The obvious and vital difference to 2014 is the slowdown in China, which is becoming more obvious by the day. This has significantly escalated the risk of emerging market and global deflationary shock via falling commodity values. The clear message to take from the Fed’s decision is that confidence in global growth prospects is slipping. Unofficial GDP forecasts for China are falling and this is contributing towards what’s becoming a traditional autumn reset of expectations.
Overall, this is by no means as drastic as recent years. In the last week, the OECD dropped its global GDP forecast from 3.1% to 3%. But, as we’d said before, it’s the distribution and divergence that matters. The OECD’s 2016 GDP growth forecast for China in 2016 has dropped to 6.5%. Brazil is now expected to stay in recession through 2016 – versus the slight recovery predicted just a few months ago. Meanwhile, the Eurozone looks like it’s having its best quarter for four years.
These conflicting narratives are enough to cause volatility in themselves as investors swing between hopes and fears, but what complicates reaction further is what might be termed a ‘misallocation of capital’. Over seven years of ultra-low interest rates, investors have scurried along the yield curve into riskier and unfamiliar assets. Capital is focused in areas that aren’t best placed to withstand US interest rate increases alongside global growth shudders. This often means that there is no consistency – or proportionality – in market reaction.
Investors’ fears tend to come in waves as they wrestled with a mass conflicting emotions – primarily liquidity hopes for these riskier assets versus slowdown fears. Last week emerging market equities rose on the back of the Fed’s hold – even though rising risks in these markets was the prime reason for the FOMC’s decision! But hey, never mind the message, feel the liquidity! Then, Credit Suisse’s multiple mining downgrades appeared to hit markets hard on Tuesday, even though the broker said that they were effectively playing ‘catch-up’.
Hostages to fortune
In this context, the FOMC’s decision looks understandable and minimal inflationary pressure appears to give them breathing space. They don’t want to move too soon and repeat the ECB’s mistake. But, this then begs the question: what will change by October or December?
It seems unlikely that the US economy will gather so much momentum that it can discount the global shudders. The Fed has downgraded its US GDP forecasts for 2016 and 2017. And of course, by tying emerging market fortunes to the Fed rate rise, it means those markets will naturally shudder more on any hint of hike, making it arguably more difficult for the Fed to move – or communicate its intentions. If the Fed is waiting for calm, clear waters it could be waiting a long time – not least because its every hint makes so many waves. As much as the Fed tries to prepare investors and markets, some pain is inevitable as capital allocation readjusts – perhaps very swiftly, as we’ve seen before. The Fed will need to be brave to move – pain is unavoidable.
Lower for (even longer)
So is 2015 still on the cards? May-be not. Equally, in the UK, the timetable appears to be slipping. The EY ITEM Club believe the first rise won’t come until Q3 2016. Last week, Citi pushed its forecast to the end of next year. This week RBS moved theirs from February to August 2016 with a ‘terminal rate’ around 2.0%. All this with wages rising at their fastest rate since 2009 and unemployment at 5.5% . This really is a very different kind of cycle.
All change in oil?
So what of oil? Fed inspired global economic jitters helped to send prices for Brent below $48 a barrel again at the end of last week and this low price is obviously biting hard now. According to Moody’s, the oil & gas industries total cash flow could contract by 20% or more in 2015, with only a modest recovery expected in 2016. That’s the headline hit, but it’s the volatility – almost more than the absolute price – which is perhaps the bigger issue here. It would be hard to manage any business when the price of your product changes 25% in three days. It’s especially difficult in the oil & gas sector, where success is based on long-term planning and investment.
This is obviously changing the capital environment and in different ways to the last time oil price dipped, after Lehman. Back then, just about every sector was in the same depressed boat. The oil & gas sector had the advantage not only of rebounding quickly, but also with greater vim than most other industries. This made it relatively easy to attract capital for investment. This time, the sector is back in the same depressed boat, but chances of quick price recovery look remote. Moreover, oil & gas is under pressure just as many other industries recover – indeed, as they profit from oil’s decline. This means growth investors are thinner on the ground. The industry reaction has obviously been to sell, consolidate and cut costs. This cost-price deflation is providing a buffer for producers, but is passing significant pain again through the suppliers – as we’ve seen in recent profit warnings. We’re also likely to see different capital dynamics as we see more distressed investors coming in.