Business World

Wednesday 7 December 2016

‘The Fed’s dead, baby. The Fed’s dead...’

Paul Sommerville

Published 07/02/2016 | 02:30

Janet Yellen, chairperson of the US Federal Reserve. Photographer: Andrew Harrer/Bloomberg
Janet Yellen, chairperson of the US Federal Reserve. Photographer: Andrew Harrer/Bloomberg

The fairy-tale that is the US’s economic recovery is coming to a shuddering halt. The patient has been in an induced coma for seven years, dosed with such potions as Quantitative Easing 1, QE2, Operation Twist, QE 3 — and, of course, the infusion of a seven-year drip of zero interest rates.

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This has led most commentators to conclude that progress was being made and the prognosis was good. Unfortunately, when the medicine is withdrawn, the stark reality is that the patient is still very sick.

A year ago, the estimates for fourth-quarter GDP 2015 growth were above 3pc. The numbers were released last week at a paltry 0.7pc and are likely to be revised lower. In fact, each and every estimate for US GDP growth has been estimated higher the further out you go, only to be revised lower nearer the time. These cows are small, these cows are far away.

The US’s fourth-quarter earnings season is under way, with revenues estimated to fall 3.5pc from a year ago. Revenue declines are now stretching across four quarters in a row — a feat we have not seen since the financial crisis. Earnings per share look even worse. Despite the financial engineering and accountancy trickery of share buybacks (which reduce the number of outstanding shares and thus increase the earnings per share), EPS in Q4 are set to fall 5.8pc.

Global stock markets have had a torrid start to the year, trying to price in the slow down. Over 40 stock markets fell into bear market territory in January — that is falling at least 20pc from the peak.

The Federal Reserve increased interest rates for the first time in seven years last December — and after the latest market turmoil, many suggested it acted too soon. But the truth is that it has acted far too late.

Interest rates should have been raised many years ago, around the start of the economic upturn, in preparation to being lowered again when extra stimulus was needed. Instead, they have sat on their hands too long and have increased rates at a time when nearly every economic indicator suggests they should be lowering them.

They have missed a whole economic cycle and are now unarmed and defenceless against future shocks. The Federal Reserve has pencilled in four further rate hikes this year — but after seeing the dismal GDP numbers, the market believes the Fed will need to row back on those aspirations. Some even suggest they will actually need to reverse course completely and cut rates into negative territory and launch more QE.

The markets are slowly losing faith in central banks’ ability to control and shape the economic environment. The Fed may continue on its path of raising interest rates in the near term before reversing course — but its ability to halt any slide in the US economy is now severely neutered.

Ben Bernanke once said he would throw money out of helicopters if necessary to boost the US economy, which leads us to our Pulp Fiction inspired conclusion: 

“It’s a chopper, baby. Whose chopper is this? It’s the Fed’s. Who’s the Fed? Fed’s dead baby, Fed’s dead.”

Mad world of negative interest rate policy

The Bank of Japan surprised markets last week by announcing that it will be implementing a new central bank weapon: negative interest rates.

The reason that it was such a surprise is that only a week earlier, the head of the bank  categorically declared that he would not be doing so. In the weird world of central bankers, previous promises or declarations now mean very little.

It seems his mind was changed at Davos — no surprise there. Japan now joins an increasing club of central banks to employ the tactic. The ECB, already using the scheme, has promised to lower rates further into negative territory in March .

These increasingly abnormal policies adopted by global central banks have resulted in a bizarre scenario in which investors pay governments to hold their money. A record US$5.5trillion in government bonds are now trading at negative yields.

This means one quarter of all global bondholders will end up paying their government custodians for the pleasure of lending them money. In Europe, around half of all government bonds carry sub-zero yields. This is an unprecedented financial experiment conceived by a handful of academics and central bankers. No one knows precisely how and when this experiment will unravel — but when it does, it will be felt in every corner of the globe.

One short-term consequence is a huge collapse in bank share prices. European bank stocks are down almost 40pc from the day Mr Draghi unleashed NIRP. The plunge in European bank stocks over the past six months has wiped out about €400bn in market value.

If the world economy is gradually improving, the banking sector share prices would be expected to be leading the way. They are not — a strong warning signal that all is not well with the global economy.

The risk of ‘Quantitative Failure’ is a clear and present danger.

Oil price falls: the good, the bad and the ugly

Oil prices have fallen 82pc from the highs of 2008. But it is not just oil. Many commodities have also seen unprecedented falls. Natural gas is down 86pc; cotton, sugar, coffee are down 70pc; wheat, platinum, copper and corn are all down nearly 60pc. In short, it has been utter carnage in the commodity sector.

Previously, many analysts would assume a fall in oil of this magnitude would be a boost to the global economy. In essence, creating a ‘tax cut’ for the consumer and boosting spending. Indeed, lower oil prices are likely to help large importing countries and also lower the cost of production across many industries — thus providing a much-needed stimulus in the medium term.

Unfortunately, in the US any benefit of lower oil prices has been more than soaked up by increased medical expenses. But in the short-term, commodity price falls are having a hugely destabilising effect on world markets.

It is easy to see the evidence. Large oil and mining producers are retrenching and shedding workers at an alarming rate. From Calgary to Texas, local economies are fracturing and house prices are falling.

More broadly, this sector is a huge dividend payer to long-term investors and pension funds. Global stock prices of these companies have collapsed, fearing these dividends will not be maintained. Also, sovereign wealth funds of the oil-producing nations have been forced to sell assets in order to make up the shortfall on their oil revenues. Saudi Arabia  sold more than US$19bn worth of assets in January alone.

The ugly outcome is likely to be seen in the form of bankruptcies. Companies which have gorged on cheap credit and are highly leveraged are under threat. It is no longer if but when some large-scale bankruptcies occur. If investing in this area, the volatility is bringing huge opportunities, but it is best to stay with the top-quality names.

Simple theory suggests prices will eventually bounce, as production is just being mothballed — but theory is not reality. Opec is unlikely to agree to production cuts in the near-term. Saudi Arabia current policy is to drive the price lower, not higher, forcing higher-cost competition out of the market.

Iran is coming on stream and global markets are already overflowing with supply — some estimates suggest the oversupply is some three million barrels a day.

Further to that, Japan, India and China — three big consumers — have already stockpiled reserves. The stress on the highly leveraged companies in this sector is unlikely to abate and it’s only a matter of time before debt restructurings are forced .

From central banks to bond markets, banking stocks to commodities, the markets are ringing alarm bells loud and clear, warning that all is not well with the global economy.

As our politicians gleefully go to the polls wearing their ignorance as a badge of honour with dubious claims of economic improvements they have achieved, it is worth remembering that Ireland’s recovery was and is born of external factors. The current Government had very little to do with it.

And take note: it will be those factors that determine Ireland’s prospects, rather than anything you will hear in the next month.

Paul Sommerville is CEO and head of advisory at SAM. Contact him at paul.sommerville@sam.ie

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