Is there an “October Surprise” in store for this year? No, we’re not referring here to election year politics but instead to the global economy and, especially, the world’s financial markets. Things have been awfully quiet of late. True, the major stock market indices in the U.S. were able to reach all-time record highs in August but volatility has largely been absent from the headlines for quite some time.
During the third quarter, the Dow Jones Industrial Average, for example, traded in a rather narrow 800-point range. The Dow closed out the period with a 2.1% price gain but finished well below the August highs. In September the venerable index successfully tested support at the 18,000 level on a couple of occasions. Hence, said level appears to be important and a failed third test could lead to a sharp selloff, whereas another successful test could send stock prices soaring again to new record highs. This situation should be resolved in the near future.
Interest rates rose across the yield curve as speculation of another tightening of the monetary policy screws by the Fed reared its ugly head yet again. Pronouncements by various central bank officials clearly indicate dissension in the ranks amongst the doves and the hawks. The odds appear slightly in favor of the hawks at this point but the only thing we are prepared to rule out is an October Surprise from the Fed. Our confidence arises from the fact that the Federal Open Market Committee doesn’t meet again until November. Q.E.D.
Commodity prices generally declined during the quarter although crude oil appeared to find support at the $40 per barrel level. Both the PPI and CPI remained in the doldrums as the former was unchanged for the past twelve months while the latter climbed a meager 1.1% for the same period.
Once again we were informed that the past isn’t what it used to be as GDP growth for the fourth quarter of 2015 was revised downward from a meager 1.4% annual rate to a paltry 0.9% rate. Things were even worse in the first quarter of 2016 as the growth rate for that period was revised from 1.1% to 0.8%. In comparison the 1.4% growth rate for the second quarter (revised upward from 1.1%) appears positively robust. As is the case with Vanderbilt football, low expectations make for easier comparisons.
Jobs growth slowed in August and September and the unemployment rate edged back up to 5%. These statistics, however, are somewhat misleading. The slower jobs growth is due largely to a dearth of skilled workers and the unemployment rate moved up because the labor force grew as previously discouraged job seekers decided to look for work again. That is a positive sign and fits with the historically low rate of claims for state unemployment benefits that has prevailed for several months.
Alas, the healthier jobs situation has not yet shown up in other areas of the economy. Retail sales and industrial production declined in August and the housing sector has shown some softness of late. Here, too, however, the statistics don’t tell the whole story as services now comprise the lion’s share of the economy and that area remains relatively strong.
In the sporting news, the Cubs completed the regular season with, mirabile dictu, the best record in all of baseball. It was, in fact, the North Siders’ best season since, well, long before we were born. Unfortunately, such a record has not been associated with postseason success in the era of the playoffs. To the contrary, the team with the best regular season record has gone on to capture the World Series title on average about one year in eight. Those are not good odds for a team that has not appeared in the World Series since 1945 and has not won it since 1908.
At this seemingly critical junction (for all of us, not just the Cubs), the central bankers find themselves between the proverbial rock and a hard place. They are expected to foster a climate of noninflationary growth and, in the role as lender of last resort, be on alert for any cracks in the financial system that could turn into large fissures.
The tools at their disposal are to some degree impaired by the historically low level of interest rates. Furthermore, monetary policy affects the general economy with long and variable lag times. Imprecision is not friendly toward good policy making.
To compound this problem, global debt levels are at record highs in both nominal and relative terms. Yes, these levels now well exceed those that obtained before the financial crisis that precipitated what is now called the Great Recession. Said debt burden has a lot to do with the sub-par economic growth throughout much of the world at present. Rising interest rates would serve to increase the burden of servicing the debt.
Like monetary policy, inflation also operates with long and variable lag times. Despite the massive intervention by the world’s central banks in recent years, there has been scant inflation in evidence and actual deflation has appeared in some areas. Yet, as Herr Puhl pointed out many years ago, once inflation appears, it is too late. As they used to say in the old horse operas, inflation must be “headed off at the pass.”
We noted above that there are signs that the U.S. economy is at or near full employment. The hawks on the Fed believe that there is little slack in the system whilst the doves believe that there is more room for growth without exacerbating inflationary pressures. There are, moreover, other considerations including the apparent fragility in many European economies and their banking systems and the possibility of the same in China, where the statistics are (ahem) somewhat less reliable.
Everything considered, it appears dicier to us to raise rates than to stand pat and risk inflation getting out of the tube down the road. Happily, for us and the rest of the world, the decision is not ours to make. (And Joe Maddon doesn’t appear to need our help with the Cubs, either.)
Weaver C. Barksdale, CFA