In our July monthly report we commented on how low market volatility levels were, right across the globe, and many commentators were warning of complacency. Well, over the last two months volatility returned with a vengeance, as you can see in the ASX200 VIX (volatility) chart below.
S&P/ASX 200 VIX
The volatility was led by the US markets: over October the Dow Jones saw ten trading days of over 200 points, half of them up and half of them down.
S&P500 daily % change for Oct 2014
As we had expected, the source of the volatility was concern about what the Fed will do with interest rates. For years now markets have enjoyed and benefited from ‘ZIRP’ (Zero Interest Rate Policy), which has been helpful in underwriting strong rises across asset markets for two reasons: first, money is cheaper to borrow, and second, the return on safe investments like bonds is so lousy it forces people to take on more risk.
The challenge for the Fed is like a parent weaning their kid off training wheels: they have to convince markets that while they may think they’re reliant on added stimulus to stay up, in fact they wouldn’t take them away if they thought they would fall over. The US economy has so many positive signs it’s hard to see how the Fed could be anything but ‘hawkish’ on interest rates, that is, talking about the risk being more that they need to go up (going down is called ‘dovish’). You don’t need zero interest rates when the utilization of productive capacity is at six year highs:
United States capacity utlization
And with a housing market that is well and truly back in business.
United States existing home sales
Add to that US initial employment claims hitting a 14 year low and consumer sentiment hitting its highest since October 2007, and it’s not surprising the tone of the last Fed meeting was decidedly ‘hawkish’, but again with no strict time frame for interest rate rises outlined. Whilst that is seen as negative for markets, the reason they are hawkish is decidedly positive: the US economy is recovering steadily and no longer needs the kind of stimulus it did post the GFC. You can see why markets were all over the place.
The Euro zone continues to be the fly in the ointment. As a bloc it has the same population as the US but its GDP is 30% lower. The economic engine room, Germany, is sputtering badly, with industrial production slowing to a five year low, the business confidence survey hitting a 22 month low and talk of a potential recession. It seems Germany has been particularly affected by the Russian sanctions.
Inflation, or more precisely the lack of it, continues to haunt the EU coming in at a five year low of just 0.3% in the year to September. Five EU members saw prices go backwards. Just to remind you, the reason deflation is seen as every bit as insidious as inflation is because it stops people spending, since they expect prices to be lower in the future, and it stops companies from employing because of the slower spending – a vicious circle. A good example of how this comes about is in the UK, where farmers are complaining it costs 30p to produce a litre of milk, yet it’s being sold for 28p.
There was a time when it looked like the European Central Bank was able to save the Eurozone by just threatening to take action, now it’s actually trying to do something – buying bonds to expand its balance sheet, like the Fed did in the US – but the market is worried whether it actually has the tools and power to make a difference. One upshot of this is the EUR/USD exchange rate continues to fall as punters expect rising rates in the US and falling or flat rates in the EU.
EUR / USD
Meanwhile other central banks are doing all they can to help. The Bank of Japan continued to pledge it would inject 60-70 trillion yen into the monetary base this year (US$643bn); it needs to do something given GDP is down 0.1% year on year. And the China Central Bank is reportedly injecting 200bn yuan (US$33bn) into some national and regional lenders to stimulate growth. The IMF would undoubtedly applaud given their call for “bold action” to bolster the global economy (Sir Humphrey would be so proud), as they yet again downgraded their forecast for economic growth.
Oils ain’t oils
The US has passed Saudi Arabia as the world’s biggest oil producer and is also the world’s biggest gas producer. US production in oil and gas related products is about 11.5m barrels a day. Oil imports are expected to provide just 21 per cent of US liquid fuel consumption next year, down from 60 per cent in 2005. Most of the ramp up in production from Coal Seam Gas and fracking. However, the increase in production has seen the oil price fall almost 30% in four months.
That’s great for consumers, but not so great for inflation and producers, many of whom are losing money at current prices. That’s another way of saying don’t expect these very low prices to stay that way.
Producer country budget breakeven prices
Source: DB Emerging Markets Research
Deals, deals, deals
Worldwide equity capital market deals – from flotations to rights issues – totalled $US678.1 billion in the first nine months of 2014, 25% more than the same period last year and the highest since 2007. European deals hit their highest since 1980. Initial public offerings stole the limelight, almost doubling from last year to hit $US176.1 billion worldwide. And loads more to come apparently.
The good stuff
Amidst all the drama it’s good to celebrate the positives. Doctors in Poland transplanted cells from a paraplegic man’s nose into his spine and successfully created a ‘bridge’ for his central nervous system to repair itself. He is now able to walk with a frame and drive a car. What an amazing achievement.