Market Commentary

Q3 2015


The feature of the past month (and indeed the past few months) has been the Fed’s vacillation regarding its widely anticipated rate rise. After seven years of near-zero rates [CHART 1], it has continued to dither when it comes to raising interest rates. Initially the delay was justified by the lingering impact of the Great Recession, but the US economy has recovered quite significantly since the dark days of 2008 and 2009 (now some six years ago!). By explaining that its decision was ‘data dependent’, it was always easy to find one data series that kept the committee on hold.

But the US economy is now in remarkably good shape – and has been for some time.The Q2 GDP growth has been revised up from 3.6% to 3.9%, an enviable pace for any developed economy. Unemployment has fallen to seven year lows [CHART 2], household net worth is at an all-time high, initial jobless claims are running at 40 year lows, the household debt-service ratio is the lowest in over 25 years and corporate balance sheets are extremely healthy with liquidity at near-record levels. Janet Yellen has indicated that when the Fed does eventually raise rates by the expected (hardly dramatic) quarter point, it will ‘continue boosting short-term rates at a gradual pace’. Judging by the restraint that has preceded the first rate rise, you can bet that ‘gradual’ will be very gradual and highly unlikely to even modestly inhibit economic growth.

However, at the latest Fed meeting it introduced a new concern: ‘global economic and financial developments’. This clearly related mainly to China where several growth metrics – such as industrial production and fixed asset investment – came in below expectations. Several subsequent economic releases added to the gloom: the forward-looking manufacturing Caixin PMI dropped to a 6½ year low of 47.2 (the sixth successive month below 50) and industrial profits collapsed by 8.8% in August. Fears of a hard landing in China thus resurfaced and investor attention switched from the strong US recovery to the Fed’s new worries about world growth.

So, instead of calming a market that usually thrives on low rates, the delay in raising rates introduced renewed uncertainty which the subsequent Chinese data appeared to confirm. As a consequence, equities (which were consolidating at the recent lower levels) declined quite sharply towards the August lows and are now seriously challenging those technical support levels.

We should not lose sight of the fact that the US is a comparatively closed economy (90% is purely domestic) and thus relatively immune to a slowdown in China and other emerging economies. In the 1997/98 Asian crisis, the US economy maintained its real GDP growth above 4% in every quarter from June 1996 to December 1998. [CHART 3] The Fed must be acutely aware of this, so why did it focus on slowing world growth as a reason to delay the rate hike? Especially at a time when most global economists (and the IMF) are forecasting that we are near a turning point with higher growth projected for 2016?

There appear to be two main reasons. Firstly, the Fed is clearly very sensitive to global financial conditions and appears ready to respond to any weakness in equity markets (and we have certainly had that over the past two months!). [CHART 4] Secondly, Congress is about to face another debt ceiling/debt default crisis in coming weeks. The risk of another government shutdown and the inevitable financial instability that generally results (hopefully not as severe as the 2011 debacle), could well have stayed the Fed’s hand – particularly in a pre-election year. (Indeed, with House Speaker Boehner having resigned and no-one left to control the Tea Party this could well be another headwind the US market has to face.)

Although the US should be relatively well insulated from the declining growth in China and Asia particularly, its equity markets have fallen almost as heavily as the world index. While this has allowed equity valuations to improve quite markedly, it is clear that the prevailing negative sentiment will persist in the near-term. Expect heightened volatility.