"Kee" Points with Jim Kee, Ph.D.

Markets sold-off last Thursday and rebounded strongly last Friday. The Thursday sell-off was prompted by the European Central Bank’s decision to lower deposit rates from -.2% to only -.3% instead of the anticipated -.4%/-5%.  The ECB also announced a 6-month extension of its 60 billion euros per month ($68 bb) bond purchase program, whereas the market expected an increase in the monthly purchase rate (not just an extension). The idea behind negative rates is to get banks to lend to businesses rather than just holding onto money (deposits). Many feel that ECB head Mario Draghi’s “restraint” was out of fear that an overly aggressive ECB might cause the Fed to hold off on its plans to raise rates soon, which would probably add to market angst and turmoil. My sense is that market participants had gone a little overboard developing a narrative that the ECB would make a huge move – beyond what had been articulated by the ECB. In that sense the immediate negative reaction, including the BIG 4% rise in the euro, should be more temporary than permanent. And in fact on Friday a decent payroll (monthly jobs) report sent stocks on a huge rebound (2%). The jobs report signaled that things in the US look okay (consistent with Fed Chair Yellen’s recent remarks) and that the Fed is still on track to initiate a rate hike soon. There are some worrisome issues (like rising credit spreads) which I’ll touch on next week.

 

Every Fed Chair has to be sensitive to what might be called political issues. For Ben Bernanke, I think it was definitely the need for fiscal (tax, spending, regulatory) reform, not just monetary loosening. Bernanke hinted at the need for fiscal policy reform in his speeches here in the US, but was a little more adamant when speaking abroad and during his final year. With Janet Yellen I think the sensitive issue is the declining labor force participation rate, which has now fallen to the levels of the 1970s. The Labor Force Participation Rate is the percentage of working-age persons who are either employed or unemployed but looking for a job. It had been rising since the 1970s and in fact peaked around 2000 with the tech boom (probably overshooting). It has since been declining, and the rate of decline has been accelerating since the 2008 financial crisis. Interestingly, business investment spending (a key driver of economic growth) has also been weak since the tech bust of 2000, and the two are probably related. A recent Aspen Institute study has shown that business investment spending has been declining even as corporate profits and cash flow generation have hit record highs. The study cites the work of economist Stephen Davis which illustrates that policy uncertainty with respect to tax rates, regulation, and spending/funding increased noticeably since 2000. That policy uncertainty is a likely source of limited investment spending, hiring, and thus growth.

 

Since policy uncertainty has increased under both Democrat and Republican regimes, the solution to resolving should also fall along non-partisan lines, and it does. Take the following “Three Principles for a Vibrant Economy” from economist George P. Schults’ memoirs:

 

1.       Keep the regulatory system clear, simple, easy to administer, and then live with it.
2.       Keep the tax system as simple as possible.
3.       Make economic polices predictable.

 

The case here isn’t for more or less government, or taxes, or regulatory oversight - just clearer and more predictable policies. The argument is for more simplicity and permanence, and I think it is an accurate one.

 

We’ve had another terrorist shock in this country. I’ve said in the past that market reactions to these types of shocks tend to cause just temporary deviations to overall market trends. Wealth is created by production and exchange, and terrorist activities can only permanently affect economies and markets if they can permanently interfere with production and exchange (9/11 did that for a time). In an interesting way, economics has a lot to say about fighting terrorism. In particular, the work of Nobel Laureate Frederick Hayek showed that knowledge in the world is fragmented and decentralized, often times known only to the “man on the spot” as Hayek would say. That’s also no-doubt true regarding knowledge of terrorist activities (turning garages into bomb-making factories, etc.). Top-down “dot connecting” activities by security agencies are crucial to be sure, but they are likely to be much more effective when informed by day-to-day citizens, i.e. the man-on-the-spot. So I would expect to see more prevalent terrorist activity hotlines going forward, and my point is that it is a good thing, from the perspective of economic theory.

 

Finally, this from Christian Ledoux, CFA®, STMM’s Director of Equity Research. There was big news from the OPEC meeting that happened last Friday. Most had expected the cartel not to cut production, but the group surprised the market with a decision to operate without a production target for the first time since 1982. It’s now basically every member for themselves. The response from oil markets was swift and negative. I’ve mentioned before in Kee Points that what we seem to be witnessing is the collapse of the OPEC cartel.