Since the middle of August, the equity markets have been volatile, caused by a potential shift in monetary policy here in the US. Since the Financial crises of 2007-2008 all central bankers followed the same policies: easy money and low interest rates. The policies, it seemed, were coordinated flowing in the same direction. The choppiness in the markets today is like two bodies of water with two different currents coming together.
When we look at monetary policy here in the U.S., we have had near zero interest rates since 2008. The Fed had no alternative, given the absence of fiscal policy and the markets -- and the consumer became accustomed to the low-interest-rate environment. It will have to be undone very gradually over a long period of time to avoid any sort of hard landing. The Fed will meet December 15 and 16, where it is widely expected the Federal Funds Rate will be raised by 25 basis points, the first hike in nearly a decade. Additionally, guidance about future rates will most likely also be communicated during that time.
In Europe, central bankers are heading in a completely opposite direction. Mario Draghi, the head of the European Central Bank (ECB), has recently said that it will do it whatever it takes to bring more inflation to the continent. The ECB has in the past year launched its own form of quantitative easing (QE) and already have negative interest rates. Economists in Europe predict still lower rates and more QE.
In Japan, there is another set of issues. Japan has entered into a recession. A few years ago, the Japanese adopted Abenomics, named after Prime Minster Abe, to stimulate the economy. The Bank of Japan had its own form of QE as well. Moving further east to China, that country, too, has had slowing GDP growth since 2010 and face a similar slowdown. The Chinese have instituted a series of moves to stimulate growth. They have done this through currency devaluation and interest-rate cuts. To the South, Brazil has had a horrible economic slowdown that started in 2014.
The price of commodities such as oil and copper have fallen dramatically this year. There are two factors for commodity prices: supply and demand; and dollar strength. The dollar plays a strong role in commodity pricing, since almost all major commodities are priced in dollars. They have an inverse relationship because when the dollar strengthens its take less dollars to buy the same amount of a commodity. 2015 saw a double-whammy on most major commodities, because the demand of commodities like oil declined, while supply increased. Additionally, the dollar strengthened, exacerbating the problem.
So, while the global economy seems to be slowing and central banks are trying to stimulate their economies, the U.S. Federal Reserve may soon set down a different path. The Fed is the most powerful central bank in the world and what the Fed does will send shockwaves around the world.
This can do nothing but produce volatility.
First, it will cause a shift in currency values. The dollar will most likely continue to strength vs. other currencies, which will continue to add pressure to an already weak commodity market. Depending upon the way the equity market views this it could have a positive or negative impact. If the market views this continued decline has a sign of a global economic slowdown the market will likely be weaker. If the market views this as cost savings for corporations and the consumer, the market should strengthen. Until these variables are sorted out it will be a cause for concern for the overall markets.
Additionally, trade wars may result, caused by declining currency values resulting from central bank actions of QE. It will be become more expensive for foreign buyers to buy U.S. goods, while it will become cheaper for us to import goods from abroad. This would hurt multinational corporations that have sales overseas. While these companies feel the positive benefits of weak commodities, they also feel the pinch of exporting goods. If earnings of companies are affected negatively it could also put pressure on the equity markets.
The final factor that will add further choppiness will be the Presidential election. Take the politicization of topics dear to the markets. When Hillary Clinton tweeted about the need for price controls in the pharmaceutical industry, it sent the sector into a tailspin. Many of the candidates have discussed health care, defense spending and environmental issues -- all of which have U.S. government policies and programs that could effect the markets if changed in any way. This will all lead to more uncertainty.
It is unlikely that the equity markets in 2016 will be as calm as the first half of 2015. It will most likely resemble the environment of 2015 after mid-august. The turbulence will most likely persist for most of this coming year until many of the factors discussed above are settled and stabilized. However, until we reach such a point, the expectation should be for a relatively flat equity market with plenty of volatility.
Disclosure: Mott Capital Management, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.