Economic Monitor – Weekly Commentary
by Scott J. Brown, Ph.D.

Market worries, real and imagined
August 31 – September 4

Financial market participants were beset with a number of worries in August. However, as a general theme, investors often worry about things they shouldn’t worry about and don’t worry about the things that they should worry about.

The drop in China’s stock market is essentially an unwinding of a speculative bubble. As such, it’s not necessarily a sign of weaker economic growth in China, nor will the market’s decline lead to economic weakness. However, there are plenty of signs that the Chinese economy has slowed. That’s the real worry. History has shown that preventing a bubble is problematic. Efforts to stop the bubble from collapsing are almost always futile, but policymakers should be prepared to deal with the unpleasant aftermath when it bursts.

China’s “devaluation” has been described as an effort to spur exports, a first salvo in “a currency war.” However, according to the People’s Bank of China, the move was meant as a transition to a more market-based exchange regime. China’s leadership wants the country to play a larger role in global finance and the yuan to be among the major currencies in the world. The IMF indicated that it would consider adding the yuan to its benchmark basket (along with the dollar, the euro, the pound, and the yen). However, to do that, the exchange rate would have to be determined by market forces instead of set at the whim of Chinese officials. After two sharp drops in the yuan against the dollar, the PBOC had had enough and declared that the currency adjustment was “essentially complete.” The currency has depreciated by about 2.8% – not a huge move. A number of U.S. presidential candidates have railed against China’s manipulation of its currency. However, the PBOC is acting to keep the yuan from weakening, not strengthening.

Again, the real worry about China is slower growth. The official economic figures (7% GDP growth) are suspect. While the country has grown rapidly is recent decades, it faces a tough transition to a better-balanced, demand-driven economy. In coming years, we’re likely to see 4-6% growth, but it could be even lower if problems increase. The country needs more consumer spending. The collapse of housing and stock market bubbles, and a contraction in the country’s shadow banking system make that a challenging goal in the near term. The ham-handed efforts to prop up the stock market and the PBOC’s clumsy attempt to move to a new exchange rate regime haven’t done much to instill confidence in the country’s leadership.

The direct impact of China’s slowdown on the U.S. economy should be small. However, one concern is that China’s woes will lead to contagion to other nations. China accounts for a large percentage of exports from a number of “commodity countries.”

The other major market worry is the Fed. Officials have made it clear that conditions are expected to warrant the first step in policy normalization – that is, an initial increase in short-term interest rates – by the end of this year. The stock market’s fear of the Fed is not well-founded. It shouldn’t really matter whether the Fed begins to raise rates in September, late October, or mid-December. The important thing is the pace of tightening beyond that first move. Officials have repeatedly indicated that conditions are expected to warrant a gradual pace of tightening.

Much of this appears to mirror the “taper tantrum” of 2013. Amid QE3, Fed officials began to talk about reducing the monthly pace of asset purchases. Markets freaked out. Bond yields rose. The Fed delayed its decision to start tapering, but when the Fed did begin to taper, long-term interest rates drifted lower, not higher. We may be seeing on over-reaction now in equities.

If not for August’s financial market turmoil, the Federal Open Market Committee would very likely have begun rising short-term interest rates at the September 16-17 policy meeting. While apparently still on the table, a September move is a lot less likely now. The economy has made enough progress and is strong enough that it can easily withstand a small increase in rates.

Inflation has remained low. The core PCE Price Index, the Fed’s chief inflation gauge, rose 1.2% in the 12 months ending in July, a long way from the Fed’s official goal of 2%. Inflation has been pushed lower in recent months by the drop in oil prices and the stronger dollar. Oil prices aren’t going to fall forever and the dollar should stabilize – and inflation should move somewhat higher – but the near-term inflation outlook should allow the Fed to take its time before beginning to raise rates.

Still, the stock market need not worry about the Fed raising rates. A hike would signal that the recovery has progressed sufficiently and the Fed is confident that growth will continue.

China and the submerging market outlook
August 24 – August 28

China’s economic slowdown may not be much of a direct drag on U.S. growth. While U.S. exporters will have a tougher time, the drop in commodity prices should help consumers and domestic producers. However, the country’s difficulties need to be considered in the broader view of emerging market troubles.

China’s stock market appeared to be undervalued in early 2014. The housing market collapse encouraged investors to put money back to work in the stock market. The Shanghai Composite Index rose more than 150% y/y, before beginning a 32% correction on July 8. Most companies in the index are partly state-owned, and the government has made a number of efforts to prevent the market from falling. The drop in Chinese equities does not seem to be related to the slowdown in economic growth (which was apparent when share prices were rising), nor is the market correction likely, by itself, to dampen economic growth. However, China’s economy has slowed, adding to worries about emerging economies in general.

U.S investors typically concentrate on the dollar index, which is based on a basket of six currencies (euro, Canadian dollar, yen, pound, Swiss franc, and Swedish krona). The Federal Reserve constructs another trade-weighted dollar index, which covers the other currencies. While the dollar has been essentially range-bound against the major currencies since mid-March, it has rallied more than 6% against the other currencies in the last three months (up more than 14% y/y). These countries account for about 51% of U.S. exports and about 57% of U.S. imports. Hence, while corporate earnings from the major-currency countries may be stabilizing, we should see a hit to those exporting to the “other” countries (bear in mind that earnings from abroad depend on growth as well as currencies).

The U.S. domestic economy stands to benefit from the drop in commodity prices. Gasoline prices should fall (refinery damage and maintenance may limit that in the near term). Lower costs of raw materials are likely to help shore up manufacturer profits.

China’s ham-handed attempt to prevent its stock market from unraveling and its clumsy, ill-fated attempt to move to a more market-based exchange rate regime have not done much to instill confidence in the country’s leadership. Capital outflows often lead to a worsening of conditions, creating more incentive for capital to flee (a vicious cycle). The direct impact on the U.S. economy may be relatively limited. However, China’s difficulties only add to worries about a broader slowdown in global growth. The longer-term outlook for these countries remains promising, but they’ve all stumbled badly recently. Moreover, China’s slowdown is likely to have a greater impact on other countries (for example, those exporting raw materials) than on the U.S.

These developments complicate the Fed policy outlook. The Fed does need to begin moving toward a less accommodative policy position at some point, but global worries and downward pressure on commodity prices should delay the initial move.

China, the Fed, and commodity prices
August 17 – August 21

The People’s Bank of China, the country’s central bank, moved to allow its exchange rate to be determined by market forces. After two sharp declines in the yuan, the PBOC apparently had had enough and declared that the currency adjustment was “basically completed.” The news from China added to uncertainty about what the Fed will do in September. Concerns about the pace of global growth have put downward pressure on commodity prices, which may keep the Fed on hold.

China’s leadership wants the yuan to become one of the premier reserve currencies, but that means that the exchange rate will have to be set by the free market. The PBOC allows the currency to trade in a 2% range around a level announced before the market open. The PBOC said it would begin setting that level at the previous session’s close (rather than picking it out of thin air). Investors took the currency down 1.9% after the news and the exchange rate dipped further in the following session, before the PBOC intervened to prop it back up.

The decision to move toward a free market confused global financial market participants. The financial press described it as “a devaluation” and some viewed it as “the start of a currency war.” Granted, China’s currency has had a strong tie to the U.S. dollar, which has become harder for the country’s exporters as the greenback has strengthened over the last year. However, the decision to intervene suggests that the PBOC had badly misjudged market forces and the likely reaction to the change. The U.S. market reaction to China’s currency debacle (and to its recent stock market correction) seems way overdone. The more important issue is the slowing in China’s economy.

The market odds of a September 17 rate hike from the Fed have varied considerably in recent weeks. Note that the market odds of a Fed move are not directly observable, because the FOMC will announce a target range for the federal funds rate rather than a specific level. However, if we assume that federal funds will trade around the midpoint of that range, we can use the federal funds futures market to calculate “odds” (I’ll put quotes around that to emphasize the fuzziness of the estimate).

If the trend of improvement in the job market continues, we should be close to normal conditions in late 2016 or in early 2017. Policy is extraordinarily accommodative now and will still be very accommodative after the first few rate hikes, so the Fed would appear to be justified in beginning a gradual process of normalization. However, officials have indicated that they need to be “reasonably confident” that inflation will move toward the 2% goal. Lower commodity prices, lower import prices, and the lack of meaningful wage growth ought to give pause.

Most likely, the FOMC will err on the side of caution and delay. The Fed does not want the initial move to be a surprise for the markets. Fed Chair Yellen will not attend the Kansas City Fed’s annual monetary policy symposium next week, but expect her to add a speech to calendar in the next few weeks.

The opinions offered by Dr. Brown should be considered a part of your overall decision-making process. For more information about this report – to discuss how this outlook may affect your personal situation and/or to learn how this insight may be incorporated into your investment strategy – please contact your financial advisor or use the convenient Office Locator to find our office(s) nearest you today.

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