Will the Tail Wag the Dog?

Global economic conditions do not appear to be severe enough to justify this year’s adverse market action. However, the adverse market action may pose a risk to the global economic outlook. While the global financial system may currently seem a bit unstable, it’s unlikely that fear will become a self-fulfilling prophecy. At least, that’s the hope.

Currency attacks on individual countries are a well-known phenomenon. Something bad happens. Investors start pulling their money out of the country. That puts downward pressure on the currency, creating more incentive for investors to pull their money out. Central banks can try to break the cycle and keep capital from fleeing by raising interest rates, but that slows the economy. This pattern was repeated across several countries during the Asian financial crisis of 1997. China is seeing such a run now. The country still has a large trade surplus, but outflows have exceeded that, putting downward pressure on the yuan. Most of this appears to be due to Chinese investors looking to put more of their money overseas (seemingly justified by expectations that the central bank will allow the currency to depreciate). China has capital controls to limit that, but most of the capital outflow appears to be funneled through Hong Kong and disguised. The central bank has plenty of reserves to defend the currency, but it has been burning through those rapidly. Last month’s decision to begin referencing the yuan against a basket of major currencies, rather than against the U.S. dollar alone, was taken as a signal that the currency will depreciate. Indeed, a lot of China’s financial woes have been self-inflicted. Authorities have been sending mixed messages.

The price of oil, as anyone who passed Econ 1 can tell you, is dependent on supply and demand. The U.S. is producing more (and importing less). The lifting of Iranian sanctions will lead to more supply. Reports have indicated a large number of filled tankers in the Gulf waiting to go somewhere. Concerns about a lack of available storage have become an issue. Where are we going to put all this oil? However, in recent weeks, financial market participants have acted as if the price of oil were more a reflection of global demand. This logic can be circular. Stocks are down because the price of oil is down, but the price of oil is down because stocks are down.

The benefit of lower oil prices to energy consumers usually outweighs the pain for energy producers. However, we have not seen as much of a boost from lower gasoline prices as we would have in the past. Consumers may have been saving a large part of the windfall, doubtful that gasoline prices would stay low. Another possible explanation is that the U.S. is simply less dependent on imported oil and domestic producers will take a hit. Energy exploration is capital-intensive and has been supported by debt in recent years. With the price of oil having fallen further, there are increased concerns in the fixed income market of widespread defaults. Data also suggest that energy-related debt has increased even more as the price of oil has declined. Pain has been felt, and will continue to be felt, by those who own that debt, but this doesn’t appear likely to be a systemic problem for the overall U.S. economy.

Last week, the International Monetary Fund lowered its outlook for global growth by a whopping 0.2 percentage points – not a huge change. However, the IMF noted increased downside risks to the outlook. These included the possibility of a sharper-than-expected slowdown in China (with more international spillover and downward pressure on commodity prices), adverse corporate balance sheet effects and funding challenges related to the tightening of Fed policy (further dollar appreciation and tighter global financial conditions), a sudden rise in risk aversion (sharper depreciations and possible financial strains in emerging economies), and an escalation of ongoing political tensions. Sounds scary, but it’s important to remember that these are risks, not the IMF’s expectations.

The global financial system appears to be much more fragile. Of Friday, the Bank for International Settlements put out a note on fixed income liquidity. To date, “the effects of ongoing regulatory, technology and market structure changes do not appear to have had large, persistent effects on the price of liquidity services for most major asset classes, but rather have been reflected in increasingly fragile liquidity conditions.”

Okay, we have nothing to fear but fear itself. While a more serious global slowdown is not expected, it remains a possibility, perhaps hastened by a fragile global financial system. After the last few weeks, investors may have more moderate expectations for 2016, but it’s the greater risk than matters.

© Raymond James

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