Stocks: The market sell-off continued last week, with the S&P 500 officially down over 10% and hitting correction territory. The average stock is down much more than that, meaning that it’s been a pretty narrow market with only a handful of winners. But that also means that the average stock is pretty cheap right now!
Economy: Kee Points readers know that I subscribe to the view that downturns and recessions are caused by economic shocks. These can’t really be forecasted, which means recessions can’t really be forecasted, but you can identify shocks that have occurred and track their impact on the economy. Currently we are experiencing the effects of three big economic shocks over the past year and a half: (1) the oil price collapse, (2) US dollar surge (3) slowing growth in China. I’ll try to say something about each that hasn’t been said before below. As for tracking their impact, right now the Atlanta Fed’s economic “nowcasting” model has 4th quarter GDP coming in at .6%, which is below consensus (Wall Street Journal Survey of Economists) estimates of 1.4%. I’ll go with the Fed’s model, so I think the fourth quarter GDP release on January 29th will likely be a negative growth surprise.
And first quarter GDP numbers tend to be low. For example, during this six-year expansion the average annualized GDP growth rate for the first quarter has been .75%. Right now the consensus is for 2.4% growth (likely to change) in the first quarter of 2016, so in my opinion that will be negative growth surprise number two. After that I think stocks will rebound. Keep in mind that the economy can adjust to just about any shock over time, and it is this adjustment that is often missed by analysts, who generally believe that a shock has to reverse itself in order for the economy to recover from it. The responsiveness of the economy both from a demand or consumer perspective and from a supply or producer perspective is greater as time passes. Economists describe this as saying “long-term elasticities are greater than short-term elasticities.” The whole commodities super cycle boom and bust is a great example of this. When Chinese demand for commodities (including oil)first appeared, the supply of those commodities was relatively fixed and prices did most of the adjusting (higher). Over time new supply sources were developed and quantity (output) increased, bringing price pressure back down.
China: Again, most China experts feel China will avoid a hard landing (e.g. Ian Bremmer of Eurasia Group and the Bank Credit Analyst in this weekend’s Barron’s). I expect a pretty strong policy response from Chinese authorities on the monetary side (lower interest rates and lower bank reserve requirements). Fiscal expansion might be a little constrained by the already huge issuance of Local Government Financing Vehicles (LGFV – known as cheng tau bonds, essentially China’s version of municipal bonds). The communist leadership in China sets spending goals, which the different local governments must help achieve. Officially these local governments are limited as to how much they can increase taxes and fees to raise revenue, so they borrow, which creates the LGFV debt. As an aside, this LGFV debt is implicitly backed by the central government, which makes them seem safer and hence easier to issue, but it also makes them possibly prone to “systemic” risk in a way that US municipal bonds are not (because they are not backed by the federal government).
Oil: Thinking in “closed economy” terms leads to error here. Closed economy thinking would argue that lower energy prices lead to more spending on non-energy items by energy consumers, but this is offset by less money to spend by energy sellers or producers. Not a bad way to think about it, but we live in an “open economy” or globally integrated world. Lower oil prices globally mean that net oil importers (those who consume more oil than they produce, which is the entire developed world) have more money to spend, while net oil exporters (those who produce more oil than they consume…Russia, OPEC countries, Texas (!)), have less money to spend. That’s what people mean when they say that lower global oil prices result in a transfer of wealth from oil producing nations to oil consuming nations. The bottom line is that, instability aside, lower oil/energy prices should be a tailwind to the global economy.
Dollar: I’ve mentioned before that, typically, dollar shocks have a big initial impact on companies and earnings, but that over time companies generally adjust. So the strong dollar should have a waning impact over time, even if it doesn’t decline. And the actual impact on companies can get pretty complex. Over 10 years ago the consulting firm McKinsey &Company issued a report arguing that many global countries sell and source (buy inputs) from all over the world, so currency impacts tend to be more muted. This insight seems to have been “re-discovered” by the press recently. As an interesting aside, smaller companies tend to generate a smaller proportion of sales overseas, so they should be less impacted by a strong dollar. But they also are less likely than large firms to have sophisticated currency-hedging programs in place. So the “size impacts” of exchange rate movements are more complicated than they seem on the surface.
Election: Finally, I promised that I would start reporting the odds on the Presidential election from Pollyvote once it started publishing them. Pollyvote was developed by Wharton’s Jon Scott Armstrong who is the world’s foremost authority on scientific forecasting methods. It is the only model I trust, as it combines expert judgment, econometric models, prediction markets, and index models. Right now the initial read is a virtual tie: 50.1% Democrat, 49.9% Republican. I’ll keep you updated as the year progresses and the forecast evolves and updates.
Posted on Tue, January 19, 2016
by Danny Aleman