Financial Review

Don’t Bet the Farm

Sinclair Noe — September 16, 2015

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DOW + 140 = 16,739
SPX + 17 = 1995
NAS + 28 = 4889
10 YR YLD + .02 = 2.30%
OIL + 2.56 = 47.15
GOLD + 14.10 = 1120.20
SILV + .53 = 15.03

The cost of consumer goods fell in August for the first time since the beginning of the year, owing mostly to another sharp drop in gasoline prices as the summer driving season came to an end. The consumer price index, or the cost of living, fell by a seasonally adjusted 0.1% last month. That’s the first decline since January. Retail prices are up just 0.2% in the past year. Excluding food and energy, so-called core consumer prices rose 0.1% in August. Core prices have risen just 1.8% in the past 12 months, unchanged from in July.

Energy prices declined 2% in August. Most of the relief came in the form of lower prices at the pump. The cost of a regular gallon of gas fell about 8% last month. The price of fuel had risen three straight months before the decline in August. Still, energy prices are down 15% over the past year. Food prices rose again, however. They increased 0.2% in August, spurred by higher costs of eggs, fruits and vegetables. The cost of airline tickets dropped for the second straight month. The price of new cars and medical care were unchanged. Lower inflation is also giving American workers more relief. Real hourly wages jumped 0.5% in August, a combination of lower inflation and a bump in pay. Real wages have climbed a modest 2% in the past 12 months.

By the way, the CPI-W is used to determine the COLA, or Cost of Living Adjustment; and it is based on the third quarter Consumer Price Index for Urban Wage Earners and Clerical Workers, which came in at negative 0.3% in August. We will still have to wait for September to determine the COLA, but we know it can’t go negative, so it looks like there will be no cost of living adjustment for Social Security benefits, or anything else.

The Federal Reserve will certainly consider inflation, or the lack of inflation, in their FOMC meeting today and tomorrow. An improving labor market and a growing economy are seen giving the Fed enough fodder to justify a hike. But many analysts see enough concern over low inflation and the impact of a rate move on fragile emerging markets as likely to stay the Fed’s hand. The World Bank and the International Monetary Fund have both argued against a Fed rate increase out of concern a move could add to turmoil in emerging-market economies, which has been fueled by a collapse in commodity prices and related concerns about China’s economy and Beijing’s decision last month to devalue its currency.

If you want to understand what the World Bank and IMF are worried about, you can look to 1997 and the Asian financial crisis. In 1997, speculative attacks against the Thai baht forced the country to float and devalue its currency in a move that was swiftly followed by the Philippines, Malaysia, Singapore, and Indonesia. Then came a massive decline in Hong Kong’s stock market that led to losses in markets around the globe. Eventually the Russian ruble collapsed. Long Term Capital Management, a hedge fund run by John Meriwether and a few Nobel laureates, made some highly leveraged bad bets, and for a while it looked like the whole thing might result in a global financial meltdown.

While parallels exist between 1997 and the current emerging market selloff, notably in the form of a stronger dollar, which makes it more expensive for emerging-market countries to finance their debts, plus lower commodity prices and slowing trade, it could be more dangerous today; there are more highly leveraged hedge funds, and sovereign funds, and derivative trades. At the least, emerging market debt will become more expensive, commodities (denominated in dollars) will become less expensive, trade will likely slow, and defaults could become more common.

The Fed’s decision tomorrow will be felt around the world because the dollar is still the reserve currency and the Fed’s monetary policy determines what happens to currencies, stock markets and economies right around the world. The markets are pricing in roughly a one-third likelihood of a rate rise this week, but, in truth, no one has any real idea whether the trigger will finally be pulled or not. I think there is a much higher probability the Fed will hike rates. We’ve been warned, it has been telegraphed and signaled and communicated in almost every way other than an official proclamation. And if they don’t do it tomorrow – when will they?

ZIRP, or Zero Interest Rate Policy was instituted in response to emergency financial conditions nearly 7 years ago. Where is the emergency today to justify ZIRP? The economy is less than stellar but it’s not like Lehman Brothers just shut their doors. And so my best guess is the Fed will raise rates tomorrow, but I’m not betting the farm because I don’t know what will happen. Neither do you. Plan accordingly.

Home-builder confidence in the market for newly constructed single-family homes rose a point to 62, the highest level since Nov. 2005, according to the National Association of Home Builders/Wells Fargo housing market index. Any reading above 50 indicates good conditions.

The Energy Information Administration reports oil stockpiles slipped 2.1 million barrels last week. Refineries increased operating rates for the first time since July, and supplies of gasoline and distillate fuels surged. Stocks of oil exploration and production companies rallied, while those of refiners fell. WTI crude rose 5.7%; it was the highest close and biggest one-day gain since Aug. 31.

So, how is the economy on Main Street? The Census Bureau has some answers. The median household income was $53,657 last year, down from $54,462 in 2013 but not statistically different. The poverty rate was 14.8%, which means 46.7 million people were impoverished — the fourth straight year in which the number of people in poverty was not statistically different. The percentage of people without health insurance coverage for the entire 2014 calendar year was 10.4%, down from 13.3% in 2013.

The Obama administration has begun preparations for a possible federal shutdown next month as a series of obstacles threaten a repeat of 2013. Lawmakers have just 15 days to reach a budget agreement before September 30, when current funding expires.

Snapping a major two-day slump, China’s Shanghai Composite Index jumped 4.9%, with all of the gains coming one hour before markets shut in a pattern that’s generally interpreted as government intervention.

Japan debt ratings were cut today by Standard & Poor’s over doubts the government will revive economic growth and end deflation in the next two to three years. The country currently has some $450 billion of debt outstanding; and the credit rating was cut to AA- rating instead of an A+ report card. The S&P downgrade is the most recent of the major credit-rating companies to do so; Moody’s was the first, in December 2014, followed by Fitch in April. S&P justified its downgrade by saying that the outlook for Prime Minister Shinzo Abe’s “Abenomics” program is grim.

Eurozone officials are racing against the clock to restructure Greece’s banking system before new rules kick in that could wipe out corporate deposits and result in disastrous effects for the country’s economy. The rush has been complicated by Sunday’s snap parliamentary elections, which could produce no clear winner and prolong negotiations over a governing coalition.

Anheuser-Busch InBev has informed rival SABMiller that it intends to make an offer to acquire the British firm in a deal that would bring together the world’s two largest beer makers. SAB Miller issued a statement saying, “No proposal has yet been received and the board of SABMiller has no further details about the terms of any such proposal.” So, the deal is far from certain, but if it happens, it would probably value SAB Miller around $75 to $92 billion, and create a brewing giant that would dominate much of the global beer market; which raises some questions about whether such a deal could pass anti-trust muster.

Also, since Anheuser Busch InBev is now a Belgian company trying to acquire SABMilller, a British company, there are some unique rules that come into play. Stringent rules on disclosure require a company to confirm or deny any hint of a deal, whether that comes from an anonymously sourced news article or unusual stock movement. The disclosure triggers a 28-day timeline for a formal, fully financed bid. Known as the put-up-or-shut-up rule, if AB InBev decides to walk away from the transaction it can’t come back for six months.

General Motors has agreed to sign a deferred-prosecution agreement to end a US government investigation into its handling of an ignition-switch defect linked to 124 deaths. The company will pay less than the $1.2 billion that Toyota paid to resolve a similar case, but the exact amount was not immediately known. The deal means GM will be charged criminally with hiding the defect from regulators and in the process defrauding consumers, but the case will be put on hold while GM fulfills terms of the deal.

The United Auto Workers union has reached a tentative labor deal with Fiat Chrysler after a long drawn-out night of negotiations. The union hopes the terms can be used as a template for Ford and GM, which also extended their deals past a midnight deadline on Monday to allow more time to wrap up negotiations. Under the agreement, Fiat Chrysler will eventually phase out the two class wage system between new factory workers and more senior employees.

FINANCIAL REVIEW

Some Perspective on the Markets

Sinclair Noe — December 16, 2014

Podcast: Play in new window | Download (Duration: 13:16 — 6.1MB)

DOW – 111 = 17,068
SPX – 16 = 1972
NAS – 57 = 4547
10 YR YLD – .04 = 2.07%
OIL – .58 = 55.33
GOLD + 1.50 = 1196.00
SILV – .47 = 15.82

Allow me to provide some perspective. On December 5th the S&P 500 index hit an intraday high of 2079 and a closing high of 2075. That was 7 trading session in the past, which may be a long time if you are trading on the minute bars, but in the grander scheme of things it was just a few days ago. The downturn has been fast and sharp, as downturns are want to be. This downturn has lopped about 90 points off the S&P, or about a 4.3%; which does not qualify as a correction and certainly not a crash, but it does catch your attention.

Both the S&P 500 and the Dow Industrials have dropped below their 50 day moving averages. The Nasdaq Composite has pulled back close to the 50 day moving average. You will recall that stocks hit highs in September and then pulled off sharply in October; from October until 7 sessions ago, the Dow and the S&P just shot higher. With the recent downturn, the major averages have taken out the highs from September, which is to say we have broken near term support.

Then consider that December is usually one of the better months on Wall Street; and you’ve probably heard about the Santa Claus rally, which is the idea that there is happiness and good will on Wall Street… No wait. It is the idea that there are people investing Christmas bonuses, also some tax considerations (or buying after selling off the tax losses), and the idea that retail sales pick up for the holiday shopping season. And the Santa Claus rally does not apply to the entire month of December. It refers specifically to the last five trading days of the year plus the first two of the New Year. Over the past 60 years or so the rally has resulted in an average of 1.5% gains for that 7 day trading window. Of course not every year produces a Santa Claus rally, and 1.5% is good, it beats a 1.5% decline, but hardly reason for joy, or for specific trading. It sometimes serves as a more general indicator of market direction, and the easy way to remember it is the old jingle from Yale Hirsch: “If Santa clause should fail to call, bears may come to Broad and Wall.”

Today it was a Russian bear. Late yesterday we told you that the Russian Central Bank had raised interest rates from 10.5% to 17%. Imagine if the Federal Reserve hiked interest rates like that; you might, rightfully, suspect that there was an urgent problem. Russia has urgent problems. The currency, the ruble, is collapsing; capital is fleeing the country; oil, the number one export has crashed in price and now Russia faces a major budget deficit because the government is financed largely by oil revenue. The Central Bank of Russia is hoping that with interest rates so high, keeping money on deposit in Russia will start to look attractive; kind of like putting lipstick on a pig.

The Russians have tried this before, with five previous interest rate increases, usually 50 or 100 basis points at a time, which had zero effect; the central bank has spent at least $75 billion this year to prop up the ruble and that was just throwing money away because Russians pulled more than $100 billion out of the country; and so yesterday the Central Bank of Russia went whole hog. The hope is that by stabilizing the value of the currency, the interest rate increase will reduce the sense of financial panic and rapid outflows of money. Maybe. But consider the other effect of higher interest rates; it essentially puts the brakes on economic growth, or in this case economic growth just ran into a brick wall. Russia was already headed into recession, and now high rates will slow things down even more. And this is with a backdrop of 10% inflation.

The rate increase might be a last-ditch move by the Russian government to try to contain the drop in the currency without adopting controls on the flow of capital or other more extensive measures to keep money in the country. And if yesterday’s rate hike fails to stem the collapse in the ruble, then things might play out in very unusual ways. Secretary of State John Kerry suggested that Western sanctions could be removed quickly if Russia withdraws from Ukraine. At the same time, the White House announced that President Obama will sign a bill that would allow him to slap tough new sanctions on Russia.

So, it looks like Putin is getting his comeuppance, but this story hasn’t played out yet. There are no guarantees that Putin will rollover, and even if he does, there are no guarantees the Russian economy will bounce back. Instead of heading into recession, the Russian economy could run right into depression, and that might complicate a whole host of things.

Let’s set the way back machine for 1994. John Meriwether, the acclaimed head of bond trading for Salomon Brothers open a little hedge fund called Long Term Capital Management (LTCM). Meriwether brought on Myron Scholes and Robert Merton, a couple of geniuses who had earned a Nobel Prize for something known as the Black Scholes model, which was a way of pricing options over time – still used today – and really opened up the use of derivatives. LTCM was a big success, generating returns in excess of 40% in its second year.

Now let’s set the way back machine to the summer of 1997. The baht, the currency of Thailand ran into trouble and was devalued. You might not think it was a big deal; Thailand is not exactly a major player in the global financial markets, but it started a capital flight, with cash flowing out of developing Asian economies. Next thing you know the currency crises spread to Malaysia and the Philippines and South Korea. Several Asian companies defaulted. And then the crisis spread to Russia, driving the value of the Russian ruble sharply lower and the Russian stock market went into free fall.

In 1998, Russia’s central bank raised its key rate to 150 percent and it wasn’t enough to stop the flight of capital from Russia. The ruble collapsed. LTCM is heavily invested and heavily leveraged in global markets, including Russia.

Risk is generally considered to be a function of potential market movement based on historical market data. For example, the odds of drawing the ace of spades from a deck of cards is 1 in 52 because there are only 52 cards in a deck and only one is the ace of spades. But financial markets are subject to uncertainty, which is another way of saying there are an unknown number of possible outcomes in the deck, not just 52. Before 1929, a computer would have calculated very slim odds of a Great Depression; after it, considerably greater odds. Just so, before August 1998, Russia had never defaulted on its debt, at least not since 1917, at any rate. When it did, credit markets behaved in ways that Long-Term didn’t predict and wasn’t prepared for.

In August 1998, the LTCM calculated that its daily “value at risk”, meaning the total it could lose on any given day, was only $35 million. Later that month, it dropped $550 million in a day. Eventually the losses grew to $4.5 billion. And LTCM was leveraged about 33 to 1, meaning that the hedge fund only held about 3% in equity; meaning that if the hedge fund went belly up, the losses would grow as they rippled out through investors and financial institutions. Wall Street feared that its unraveling could set off a systemic meltdown. The Federal Reserve stepped in and arranged a bailout among 14 major banks to rescue LTCM. The only major bank that did not go along with the Fed bailout was, ironically, Bear Stearns. Within a few weeks, calm returned and the crisis passed.

The current situation has a way to go before it gets as desperate as the summer of 1998, but you never know exactly how and where contagion can spread. In 1998, the global financial system came close to a meltdown as a hedge fund run by geniuses failed to accurately measure risk. Fast forward to today, and substitute LTCM for a bunch of highly leveraged European banks. And just a reminder, the Eurozone is going through a bit of a rough patch itself right now.

The saga of Long-Term Capital Management looms large in the psyche of global markets, even if the lesson went unlearned. We saw another near meltdown of the global financial system in 2008 and the story line was eerily similar to the summer of 1998. Highly leveraged financial institutions used derivatives to place big bets on the subprime mortgage market rather than bets on the Russian ruble. Bear Stearns, ironically, was one of the first to falter. The risk was ill-considered. When people figured out there was a problem, liquidity evaporated. The belief that one can safely get out of a liquid market is one of the great lessons that went unlearned.

This is not to say that the collapse of the Russian ruble is going to repeat like 1998. History doesn’t repeat, but sometimes it rhymes. The ruble plummeted into a freefall, losing as much as 19% before recovering slightly (down just 5%) as panic swept across Russian financial markets after the surprise interest-rate increase failed to stem the run on the currency. But the panic in Russia spread to other developing markets from Dubai to Indonesia.

And nobody really knows how this will play out. Putin may feel pushed into a corner, he might lash out; he might think NATO is afraid of him. Imagine Cyprus with nukes. The last time oil prices experienced this kind of run-up and decline, the Soviet Union fell. If that’s not terrifying enough, consider that Russia is not the only country headed for problems. The Middle East is full of countries that need a high oil price to protect their economies.

We’re heading into the holidays, usually a good time for the markets, usually a time when you can get together with family and friends and leave all your cares behind. Stay awake kids.