As we strongly suspected would be the case, the Fed decided to do nothing last week after months of guiding markets to a September rate hike. Collapsing growth in China is likely not the only dissuading factor, though it garners much focus.
The leadership in China now regularly and openly props up their stock market after trillions have been lost. We see no choice for China but to devalue its currency some more and try to export its deflation. That prospect does not give the Fed much room to normalize policy. The central planners are starting to realize that money printing has not worked and the markets are figuring that out too. Importantly, because emergency monetary policy has been in place for seven years, it leaves the deciders with very few market-manipulating strategies from which to choose, but they will try.
As we have been discussing, a lot of things elsewhere have been pointing to a global slowdown and disinflation all year and now it is tough to find things that do not. The collapse in emerging market currencies and bonds is likely the clearest indicator that the current equity market volatility is more than a garden variety correction. It once seemed to many debt issuers outside the U.S. that the flow of U.S. currency from QE would lead to a boom that would never end and they borrowed trillions of dollars accordingly. Now the current relative scarcity of dollars since our Fed stopped printing is a major contractionary force on global growth. The collective debt service on bonds issued in dollars grows much more expensive with the stronger greenback and credit issues are surfacing in a significant way.
At the same time, lower oil prices are causing serious drama for energy producers whose cash flows are shrinking rapidly. We have no idea where oil prices are going, but we do know that defaults in the energy sector will be a major global drag. In the U.S., the shale boom drove a lot of industrial demand and now that is rolling over in a big way.
The U.S. has a major inventory problem that must be resolved and the negative print for industrial production for August may be the start of the unwind. That inventory accumulation has kept manufacturing from rolling over harder, but now those unsold goods must be worked off and that will be a problem for the rest of the year. Jobs in the manufacturing sector already were not growing in spite of all the hoopla from pundits raving about the U.S. decoupling from global woes.
Corporate earnings are becoming more of a question mark as 2015 estimates have been revised about 20% lower over the last year, so it is quite difficult for even the top-down equity exposure grabbers to persist because they must willing to stomach that they are purchasing a shrinking cash flow stream. Cyclical stocks sold off after the dovish Fed meeting last week and that is yet another sign that earnings worries have become a pronounced market impediment.
Of course, the problem with the massive QE efforts in the U.S. and elsewhere is the fact that they will likely prove impossible to stop for long until true sustainable growth emerges. This is not because these policies helped, but because they created distortions in both the real economy via currencies and debt creation and in markets via unrealistic valuations. We are not big fans of QE (to say the least) except as a last resort in a severe crisis and for a brief period of time. Nonetheless, we doubt the Fed can muster the intestinal fortitude to normalize policy when both the markets and real world data will cause many to scream for more money printing though it has done nothing to help here or in Europe and Japan.
What is interesting to us is that if the Fed were to step in and conduct more QE, then it would be doing so at a time when earnings were falling and growth outside the U.S. is quite weak. That might make the Fed reluctant to push that button in some ways. We are of the mind that QE3 was conducted when that policy had a lot of wind at its back as earnings were going to rise with or without it and growth outside the U.S. was rising. As a result, QE was given too much credit by many and that belief system might be lost if a new round does not unleash rampant speculation and improved sentiment. At that point, the tool which central banks see as the panacea would become exposed as nothing but a gimmick. Regardless, we would not be surprised if the Fed begins to make easing noises in the next few months because it is what they do. However, we cannot emphasize enough that one only need to look back to 2001-02 and 2008-09 to see that the “don’t fight the Fed” fallacy can lead to huge losses.
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