Volatility has kicked into high gear. Yesterday the VIX, the Volatility Index was up 11%, and today it dropped 12%. The Dow has had moves of 200 points or more five times in the last 10 days. There have only been 10 other days this year when the index has made moves of that magnitude. Yesterday was an ugly decline and today, stocks started drifting lower, and then suddenly, dramatically, jumped higher; by the closing bell it was the best day of the year. Send your thank you notes to Janet Yellen.
Pause for just a moment and think about what has been driving the markets for the past 5 years. Certainly, there are many factors but a big factor would have to be Federal Reserve monetary policy. Yesterday stocks looked like they were going to hell in a hand basket, and today the Fed’s FOMC minutes were released and the markets were revived as if they’d been given a big old hypodermic full of adrenaline straight to the heart.
We all know the Fed is ending its bond buying crusade this month, and the open question has been when they will raise interest rates. The minutes of the September FOMC meeting would have you believe they are in no hurry at all; they will take thing slow and easy; they want to avoid formal phrases like “considerable time” because that’s just too restrictive. They’ll follow the data of course, but they won’t rush the rates.
Also, inflation remains tame and there is no concern about inflation for a couple of years; and even though the job market has shown strength, there is still too much slack. And then there is the nagging problem of economic turmoil in Europe and Asia, plus concerns the dollar is getting just a bit too strong. Eventually the Fed will raise rates, probably in mid-2015.
The International Monetary Fund has issued its half-yearly global financial stability report, and they say the prolonged period of ultra-low interest rates encourages excessive risk taking in global markets and threatens a fresh financial crisis. The IMF report says the risks to stability no longer came from the traditional banks but from the so-called shadow banking system – institutions such as hedge funds, money market funds and investment banks that do not take deposits from the public. Policymakers are facing a new global imbalance: not enough economic risk-taking in support of growth, but increasing excesses in financial risk-taking posing stability challenges. Which is another way of saying the central bankers have created a financial bubble.
The stability report said low interest rates were “critical” in supporting the economy but loose monetary policies also prompted investment in high-yield but risky assets and for investors to take bigger bets. And emerging markets were considered especially vulnerable to rising US interest rates, as are we all. And so the Fed will raise rates at some vague point in the future, even as Japan sticks to Abenomics, and the Eurozone has opted for negative interest rates.
Which raises a question; what happened to the currency wars? You remember that various central banks were in heated battles to debase their currencies in a race to the bottom as a way to stimulate economies? It’s the only war the US has not jumped on. The dollar is strong and Treasury Secretary Jack Lew seems to think that’s fine and dandy.
A strong dollar is good if you are planning a European vacation; not so good if you are trying to sell Chevrolets in Germany. But for now at least, the threat of a destabilized Eurozone is a bigger threat to US growth than a possible slowdown in exports. The US has more to gain from Europe and Japan getting their policies right and getting their economies on track than it has to lose from American companies facing a less advantageous exchange rate for the time being.
As a side note, the IMF estimates that the size of the US economy was $17.4 trillion in 2014, just short of China’s economy, at $17.6 trillion. Based on purchasing power, which may not be the best way to measure, China’s economy was less than half the size of the US economy in 2005; by 2019, the IMF expects it to be 20% bigger.
Alcoa kicked off the earnings reporting season after the close of trade. The aluminum maker reported a profit of $149 million, or 12 cents a share, up from $24 million, or two cents a share, a year earlier. Excluding restructuring- and acquisition-related charges and other items, earnings rose to 31 cents from 11 cents. Revenue increased 8.2% to $6.2 billion. Alcoa beat estimates.
Alcoa marks the unofficial start of earnings season; actually the reports have been flowing in. Costco said its fiscal fourth-quarter profit rose 13% from a year earlier to $697 million, or $1.58 a share, on revenue of $35.5 billion.
The US budget deficit fell by nearly a third in fiscal year 2014. It’s still growing, just not so fast. Now it is just 2.8% of GDP. For the fiscal year ended September 30th, the Congressional Budget Office estimates the deficit at $486 billion, down about $195 billion from the $680 billion budget gap recorded in fiscal 2013. The Treasury collected a little over $3 trillion-nearly 9% more than it did a year ago-while spending rose just 1.4% to $3.5 trillion. One of the biggest drops in spending came from the Department of Defense, which cut outlays by $30 billion; that was before the situation in Iraq and Syria started to unravel.
The geopolitical problems around the world, specifically hotspots in oil producing regions of the world, should have put upward pressure on oil prices, but instead prices are down 20% since June 20th. And the reasons are basic; supply is up and demand is down. The shale boom in the US has added 1.1 million barrels a day to output, and next year that number is expected to climb to 2 million barrels a day. Meanwhile, the Energy Information Administration forecasts consumption will shrink 0.2% to 18.9 million barrels a day this year, the lowest since 2012. One reason why demand is down is because we’ve been buying new cars, and those new models are much more fuel efficient. Conservation works. Who knew?
The EIA cut 2014 and 2015 crude price forecasts yesterday because of rising production and falling consumption. WTI will average $94.58 next year, down from a September projection of $94.67. Which raises the question of why the forecast prices are higher than current prices, in light of more supply and less demand. And the answer is simple. Shale oil is expensive to extract by historical standards and only viable at high-enough prices. About 70% of US reserves would remain economic with global prices at $75 a barrel, but that means a lot of rigs would shut down before prices hit $75 a barrel, and if rigs shut down, supplies would get tighter.
Now you might think that falling oil prices are an indication of slower global economic growth, and there may be something to that idea, or it might be that conservation thing we talked about; and you might be worried that slower growth would equate to a tough time for the stock market. The thinking here is that a bear market in oil prices equals a slowdown in the economy equals a bear market for stocks. Not so fast. You could also look at higher oil prices as a tax on consumers; the more we spend to fill up the tank, the less we have for other spending. So, a couple of professors studied (1) the relationship between oil prices and stock market returns, and the basic idea is that if oil prices drop by 10%, the stock market rises by 1%; there is more to the study, but that’s the basic idea.
Lower oil prices could have lots of knock-on effects around the world. Take Russia, which depends on oil sales to bring in foreign currency. The Russian government has set its three-year budget with the expectation that oil prices would stay at $100 per barrel. Forget about sanctions, low oil prices could really cause damage.
The last time the US had a domestic oil boom was in the 1980s, following the Arab embargo. It ended when new supplies overwhelmed the market. Prices dropped to $9.95 a barrel in April 1986 from $32.35 the previous August, and the annual average stayed below $30 a barrel until 2000. We don’t know if prices will go much lower, or if something will spark higher prices. We will probably never see $30 dollar oil again, but the $80 level is an important level of support, and we’re getting close.
Yesterday, the Nobel Prize in physics went to 3 scientists who built a better light bulb; today the prize for chemistry goes to 3 scientists who built a better microscope. Two Americans and a German have received the Nobel Prize in chemistry for the “development of super-resolved fluorescence microscopy.” The laureates have expanded what we can with see with light microscopy from bacteria down to really small molecules. Optical microscopes use visible light, which doesn’t damage its subject. Electron microscopes, which can examine even smaller objects, require chemical preparation of the subject and can’t be used on living organisms. In fluorescent microscopy, proteins and other cell components are marked with luminescent molecules. It allows scientists to see molecules create synapses between nerve cells in the brain, as well as monitor the progress of proteins involved in diseases as they clump together. Basically, they figured out a way to use a microscope to look into the nanoworld; and just in case you were wondering, a nanometer is one-billionth of a meter. Now there is theoretically no structure too small to be studied.