2016_09_05 - Market Musings

Happy Labor Day! Let's get to laboring and see what's going on out there. There is a lot of news around interest rates today...most days we will not focus on interest rates because at some point it becomes quite boring...hopefully we aren't there yet. 


1. Oil Prices Jump on News of Agreement Between Saudi Arabia and Russia

Commodities and derivatives don't have Labor Day...nor does anyone besides the US and Canada. Therefore the oil market was rocking and rolling on Monday morning with news of a production agreement between Saudi Arabia and Russia.

Oil jumped early in the day and then everyone remembered that it was Saudi Arabia and Russia we are dealing with here and the likelihood of anyone actually agreeing on anything is minimal. Oil then fell back some ending the day up but not nearly as much. A few things to remember here (i) countries very rarely can agree on anything...even when it is mutually beneficial, (ii) expecting countries to abide by quotas and other revenue reducing measures is ambitious and (iii) these countries generally severely dislike each other. 

At some point something dramatic probably is going to happen regarding the oil price. Although we currently have some absolutely heartbreaking things happening in the Middle East, we haven't had a real supply shock in a very long time. US supply continues to come down (1M barrels/year over year) but the overall amount of oil being produced is still significant.

We have minimal direct exposure to oil and gas securities but oil and gas prices will play a major role in shaping the economy and the profits of a significant number of businesses even directly out the oil and gas orbit for a long time.

2. Meanwhile a lot of people think central banks should start buying stocks...

This is some next level thinking. What is the idea...the ECB (European Central Bank) should be buying stocks because bonds are running out. Taking a quick step back to remember why the central bank is buying bonds; the primary purpose was to keep yields down to stimulate the economy.

Now some people will say that getting stock prices up will also stimulate the economy...I guess. But at some point we have to be honest with ourselves...this is a bad idea. Just because some central banks (Japan, Switzerland) are doing it doesn't mean everyone should be doing it. The rationales being brought forth are pretty fantastic. Here are some from a WSJ article:

“I don’t see a reason not to do this,” said Joseph Gagnon, senior fellow at the Peterson Institute for International Economics. “It isn’t obvious to me why a central bank wouldn’t always want a diversified portfolio, including equities.”

Response: The purpose of a central bank is not to have a balanced portfolio, it is not a 45 year old planning for retirement. The purpose of a central bank at least as we define it in the US is to control inflation and strive for maximum employment...

ECB stock purchases “would be justified: European equities are undervalued, while there is a bubble—that the ECB continues to inflate—in bonds,” said Patrick Artus, chief economist at French investment bank Natixis, in a research note.

Response: It is true that when the central bank buys trillions of assets you are going to get some negative distortions. That doesn't mean they should go and distort another market just because they have distorted the bond market.

“The obvious reason for the ECB to buy equities is they have almost run out of German bonds to buy,” said Stefan Gerlach, chief economist at BSI Bank and a former deputy governor of Ireland’s central bank. “The basic idea is that the central bank can put essentially anything on its balance sheet and there is no reason to be straight-laced about this.”

Response: There is a reason to be straight-laced and smart about this. Buying bonds keeps yields down and when yields are low theoretically more people have access to credit. Low interest rates has also increased the value of stocks already.

At some point everyone is going to remember that significant distortions have real and severe consequences. And the more distortions we create the bigger the problems we are going to have prospectively no matter how high the stock market goes before then...in fact it might be worse the higher it goes.

3. The Japanese central bankers appear to be realizing that at some point enough is enough when it comes to lower and lower rates

Bank of Japan Governor Kuroda (Japan's Janet Yellen) is apparently having second thoughts about negative interest rates. Mr. Kuroda had the following to say:

The BOJ governor, speaking at a seminar in Tokyo, said negative rates particularly hit the profit of financial institutions, while low long-term yields hurt some other businesses by forcing them to put aside more money for long-term pension obligations.

The central bank must consider “that such developments can affect people’s confidence by causing concerns over the sustainability of the financial function in a broad sense, thereby negatively affecting economic activity,” Mr. Kuroda said.

What Mr. Kuroda is saying is that the banks have a very very hard time making any money with interest rates at these low levels. If the banks can't make any money lending then they won't really lend. If they won't lend the economy has a hard time growing. This is the problem that a lot of the world is currently having.

The second point that Mr. Kuroda makes is around pension obligations. This deserves its own post/multiple posts but the basic problem is that the lower your interest rates are the larger the value of your future benefit obligations. Every developed country has this problem because politicians have made promises we simply cannot afford. The good news is that man made problems have man made solutions....that solution is to push back the retirement age significantly. Honestly that doesn't bother us too much, we have 30 years to plan for this. It would be nice if someone would just be honest about it.

4. Meanwhile in the US no one thinks much of any interest rate increases

We start to get nervous when no one thinks something is going to happen. We talked about this in our last Market Musing but to repeat no one thinks we are going to get multiple rate hikes this year. There is a good reason for this, the Fed has never publicly raised in September ahead of a Presidential election (Fed public interest announcements began about 25 years ago).

It would be pretty crazy if it happened and basically no one is ready for this. At the same time no one is ready for multiple rate hikes even looking into the future. This comment is pretty spot-on:

“Even if the Fed does get in a rate hike this year, nobody’s on the page where they think this is going to set off a series of interest-rate hikes,” said John Briggs, head of strategy for Americas at RBS Securities. “It’s not like at this point last year when we thought, oh they’ll go in September and they’ll go once a quarter.”

Mr. Briggs is right in that no one expects this....that's what makes us a bit cautious.

5. Brexit has not killed the UK economy...of course they haven't even hit the button yet to leave...

The pound is still down significantly, but despite rumors of its demise the UK economy is slowly but surely trucking along.  This just shows how hard forecasting is. One thing people forget is that the markets are adaptive. Businesses are incredibly adaptive which is why it's generally a good idea, outside of times of severe stress, to allow the market forces to "run the show". Someone once asked me what makes business so adaptive. My response, "failure and destitution is a heck of a motivator". Sometimes fear is a very very good thing as it keeps everyone on their toes.