The major asset markets started 2016 on a bearish note, with most asset prices falling significantly. This uncertainty has many investors seeking clarity. In recent conversations with Michael Contursi, Executive VP of RCW Financial, a rare coin asset management firm, he indicated that many of their clients are concerned about recent volatility and asked if I could share my thoughts. While I am no expert on rare coins, I do have some strong views on the recent shocks to the global economy. In my view, there are three key areas that investors need to focus on when thinking about recent events: China, oil, and above all the Fed. Indeed the Fed directly or indirectly affects almost all of the key macro variables in the global economy. Many pundits make the mistake of what I call "reasoning from a price change". That is, they try to figure out the impact of the change in some sort of asset price, without first considering what caused the price to change. For instance, the implications of a fall in the price of oil depend at least in part on whether the decline is caused by more supply of oil (which is often bullish) or less demand for oil (which is generally bearish). Keep in mind that exchange rates and interest rates are also a type of price, the price of one currency in terms of another or the price of credit. People often talk about the depreciation of the Chinese yuan as having a "deflationary" impact on the global economy. That may be so, but it depends entirely on whether the depreciation is caused by an expansionary monetary policy in China, or contractionary monetary policy by the Fed. Only in the latter case is a depreciating yuan likely to have a deflationary impact on other countries. Every exchange rate is two-sided, and there are at least two possible explanations for any change. Chinese economic growth has been slowing for a number of years, although it's difficult to say by exactly how much, as the official data is widely viewed as being unreliable. In my view, China's economy is not doing as poorly as some have suggested, however the industrial and construction sectors are definitely slowing more than the overall GDP numbers suggest, and these are the parts of the economy that have supported the global commodity boom. Even though the Chinese service sector is expanding rapidly, these new industries are nowhere near as commodity intensive as older industries such as steel-making. While the slowdown in China has had a depressing effect on global commodity prices, it can't really explain the recent sharp drop in oil prices. The Chinese continue to rapidly expand the number of cars on the road and therefore Chinese oil demand is not the problem. Instead, the collapse in oil prices seems to result from the convergence of several other factors, especially the rapid increase in oil production in the United States due to the development of fracking. Some will argue that fracking has been expanding for years and doesn't really explain the sudden drop in oil prices. Here at think it's important to distinguish between deep causes and near-term triggers. As US oil production increased over time, OPEC (and especially Saudi Arabia) trimmed production to maintain high oil prices. Eventually, the Saudis were no longer willing to absorb a loss of market share and switched to increasing production to try to put pressure on American frackers, who have a higher marginal cost of production than the Saudis. So fracking is the deep cause of low oil prices, and is the reason oil is likely to stay relatively cheap for many decades. But events in the Middle East, including rising Saudi and Iraqi production as well as expectations of an end to Iranian sanctions, were the trigger for the sharp decline over the past year or 18 months. If declining oil prices are due to increased production, that shouldn't be bearish for the global economy. However in recent months an additional factor seems to have come into play, a slowing global economy is reducing forecasts of future energy demand. And here's where the Chinese economic slowdown comes in the picture. Lower commodity demand has helped to push Latin American countries such as Brazil and Venezuela into depression (although of course economic mismanagement also played a major role). Slower growth in emerging markets translates into slowing growth in energy demand. A combination of falling commodity prices and a strong US dollar has put pressure on many borrowers in the developing world. The third factor, and most important in my view, is an excessively contractionary monetary policy by the Federal Reserve. Many people are startled by this claim, as they associate monetary policy with the level of interest rates, which even after the recent rate increase are still extremely low. Keep in mind however, that interest rates do not measure the stance of monetary policy. Indeed it's often true that low interest rates are associated with a contractionary monetary policy and high interest rates reflect an expansionary policy. Because this is so counterintuitive it requires some explanation. If you're old enough to remember the 1970s, you might recall that interest rates were extremely high, often in the 10% to 20% range. If high interest rates were an indication of tight money, then monetary policy would of been extremely contractionary during the 1970s. In fact it was just the opposite, the Fed increased the money supply a rapid rate causing high inflation, and this high inflation is what pushed interest rates up to record levels. Today we face almost the opposite situation. The Fed has set an official inflation target of 2%. Since 2009, the Fed has generally fallen short of this target. So then why did the Fed raise interest rates in December? Top Fed officials such as Janet Yellen believe in the "Phillips curve" theory of inflation, which says that inflation will rise when the economy overheats, as indicated by the unemployment rate falling to relatively low levels. Because the current unemployment rate of 5% is below average, the Fed has concluded that inflation will increase significantly over the next few years. Unfortunately, the markets don't seem to agree, nor do I. In the Treasury bond market, you can read inflation expectations by looking at the difference in the yields on regular five-year Treasury bonds and inflation-adjusted Treasury bonds (called TIPS). Currently there is only about 1.2% spread between the two bond yields, indicating that markets probably expect significantly less than 2% inflation over the next five years. To be fair, these interest rate spreads can be biased by liquidity factors; the TIPS market is not as liquid as the conventional Treasury market, and that pushes TIPS yields up a bit higher than otherwise. However there is also a bias in the opposite direction, as the Fed is actually targeting what's called PCE inflation, which generally runs about 0.3% less than the CPI inflation that is measured in the TIPS spread. The bottom line is that PCE inflation is likely to fall short of the Fed's 2% target for most of the next 5 years. The markets don't trust the Fed's judgment on inflation---they don't believe that inflation is likely to rise up to the Fed's 2% target for any sustained period of time. When the Fed raised rates in December, FOMC members indicated that they were likely to raise the target fed funds interest rate another four times in 2016. Even then the fed funds futures markets were skeptical, and as the stock and commodity markets plunged in early 2016, they become even more skeptical, forecasting only one or perhaps two rate increases this year, not the four predicted by the Fed. Here's where it's important not to reason from a price change. You might think it's "good news" if the Fed only raises rates once this year, not four times. And other things equal I suppose it would be good news. But in this case other things are not equal, and the prediction that the Fed will only raise rates once this year is indirectly a prediction that the economy itself is going to be much worse than the Fed expects, and that once they realize this fact Fed officials will back off on their intention to raise interest rates repeatedly. Do we have any evidence to support my hypothesis? Consider the fact that soon after the Fed raised short-term interest rates, long-term interest rates actually declined slightly in the Treasury bond market. And note that mortgage rates in America are linked to longer-term Treasury bond yields. Ironically, if the Fed is trying to raise interest rates to prevent an upsurge in inflation (that the markets don't expect), then they are not fully achieving their goal. The more important long-term interest rates that impact mortgage rates are actually falling, just the opposite of what the Fed intends. Furthermore, declines in bond yields are strongly correlated with declining stock prices, indicating that both factors are being driven by the same underlying phenomenon. Perhaps you've read that low interest rates are good for the stock market. In some cases that's true, but not if those low interest rates reflect market expectations of a slowing economy. Furthermore, Fed policy has led to a relatively strong dollar in the last few years. The euro, the British pound, the Japanese yen, the Canadian and Australian dollars, and many emerging market currencies have all declined quite sharply against the US dollar. But there's one important exception, the Chinese yuan. You may have seen some headlines about Chinese "currency devaluation" rattling global stock markets. These stories are misleading, as each devaluation was only about 1% or 2% against a US dollar that was rising strongly against most currencies. If one were to compare the Chinese yuan to almost any other currency in the world, other than the US dollar, it would look extremely strong. Indeed it's actually far too strong for the needs of the Chinese economy, which is slowi
