Why It Matters If The Fed Raises Rates

628x471This summer might prove to be quite rocky for the American and global economies. The smart money is on the Federal Reserve raising its borrowing rate from a paltry 0.25% to something…marginally less paltry. But in a world where borrowing rates are already incredibly low even a modest increase has some investors shaking in their boots.

Why is this? And why do interest rates matter so much? And why should a small increase in the government borrowing rate matter so greatly? The answer has everything to do with that financial black hole 2008.

I asked NASA to use the Hubble telescope to take a photo of the 2008 financial crash. This is what it looks like from space.
I asked NASA to use the Hubble telescope to take a photo of the 2008 financial crash. This is what it looks like from space.

No matter how much time passes we still seem to orbit that particular mess. In this instance it is America’s relative success in returning economic strength that is the source of the woes. Following the crash their was a great deal of “slack” in the economy. Essentially factories that didn’t run, houses that sat empty and office space that was unused. The problem in a recession is convincing 1. Banks to lend to people to start or expand businesses, and 2. to convince people to borrow. During the great depression the double hit of banks raising lending rates and people being unable to borrow created a protracted problem, and it was the mission of the Federal Reserve in 2008 to not let that happen again.
US GDP Growth 2012-2015 source: tradingeconomics.com

To do that the American government stepped in, first with bailouts to pick up the bad debt (cleaning the slate so to speak) and then with a two pronged attack, by lowering the overnight lending rate (the rate that banks can borrow at) and then promising to buy bonds indefinitely, (called Quantitative Easing). The effect is to print mountains of money, but in ways that should hopefully stimulate banks and corporations to lend and spend on new projects. But such a program can’t go on for ever. Backing this enormous expansions of the treasury requires borrowing from other people (primarily China) and the very reasonable fear is that if this goes on too long either a new financial bubble will be created, or the dollar will become worthless (or both!).

Today the Fed is trying to determine whether that time has come. And yet that answer seems far from clear. Investors are wary that the economy can survive without the crutch of cheap credit. Analysts and economists are nervous that raising rates will push the US dollar higher, making it less competitive globally. Meanwhile other countries are dropping interest rates. Germany issued a negative bond. Canada’s own key lending rates was cut earlier this year. People are rightly worried that a move to tighten lending is going in the exact opposite direction of global trends of deflation. If anything, some argue the US needs more credit.

The question of raising rates reveals just how little we really know about the financial seas that we are sailing. I often like to point to Japan, whose own economic problems are both vast and mysterious. Lots of research has gone into trying to both account for Japan’s economic malaise; it’s high debt, non-existent inflation, and how to resolve it. Currently the Japanese government is making a serious and prolonged attempt to change the country’s twenty year funk, but it is meeting both high resistance and has no guarantee of success.

Similarly we have some guesses about what might happen if the Fed raises its rates in the summer or fall. Most of the predictions are temporary instability, but generally the trend is good, raising rates usually correlates to a stronger and more profitable market.

But that’s the key word. Usually. Usually European countries aren’t issuing negative interest rates on their debt. Usually we aren’t in quite a pronounced deflationary cycle. Usually we aren’t buying billions of dollars of bonds every month. Usually.

The answer isn’t to ignore the bad predictions, or obsess over them. The best idea is to review your portfolio and make sure it’s anti-fragile. That means incorporating traditional investment techniques and keeping a steadfast watch over the markets through what are often considered the quiet months of the year.

Will We All Be Victims of Cheap Oil?

OILEarlier this year we wrote that Russia’s economy was fundamentally weaker than Europe’s and that their decision to start a trade war in retaliation for economic sanctions over the Ukraine would hurt Russia far more than Europe. As it happened Russia has suffered that fate and had a helping more. The collapsing price of oil was a mortal wound to the soft underbelly of the Russian economy, leading to a spectacular collapse in the value of the Ruble and an estimated 4.5% contraction in their economy for 2015.

The Ruble’s earlier decline this year had already made the entire Russian stock market less valuable than Apple Computers, but as the price of Brent oil continued to slide below $60 (for the first time since 2008) investors began to loose confidence that Russia could do much to prop up the currency, prompting an even greater sell-off. That led to an unprecedented hike in the Russian key interest rate by its central bank, moving it from 10.5% to 17% yesterday. Moves like that are designed to reassure investors, but typically they only serve to ensure a full market panic. The Ruble, which had started the year at about 30 RUB per dollar briefly dropped to 80 before recovering at around 68 to the dollar by the end of trading yesterday.

The Russian Ruble over the last year. The spike at the end represents the last few weeks.
The Russian Ruble over the last year. The spike at the end represents the last few weeks.

Cheap oil seems to be recasting the economic story for many countries and millions of people. The Financial Times observes that oil importing emerging markets stand to be big winners in this. Dropping the cost of manufacturing and putting more money in the pockets of the growing middle class should continue to help those markets. The same can be said of the American consumer, who will be benefiting from the sudden drop in gas and energy prices.

The Financial Times always has the best infographics.
The Financial Times always has the best infographics.

Losers on the other hand seem easy to spot and piling up everywhere. Venezuela is in serious trouble, so is Iran and the aforementioned Russia. Saudi Arabia should be okay for a while, as it has significant foreign currency reserves, but as the price drops other member states of OPEC will likely howl for a change in tactic. But along with the obvious oil producing nations, both the United States and Canada will likely also be victims, just not uniformly.

Carbon Tracker Initiative
Carbon Tracker Initiative

Manufacturers may be breathing a sigh of relief in Ontario, but Canadian oil producers are sweating it big. Tar sand oil requires lots of refining and considerable cost to extract. Alberta oil sands development constitute some of the most expensive projects around for energy development and a significant drop in the price of energy, especially if it is protracted, could stall or erase some future investments. This is especially true of the Keystone Pipeline which many now fear isn’t economically viable, in addition to being environmentally contentious.

This chart was produced by Scotiabank
This chart was produced by Scotiabank

Saudi Arabia has continued to allow the price of oil to fall with the intention of hurting the shale producers in the United States. This price war will certainly claim some producers in the US, but it will difficult to know at which point that market will be effectively throttled. Certainly new projects will likely slow down but the continued improving efficiency of the fracking technology may make those producers more resilient to cheap energy.

But there is one more potential victim of the falling price of oil. That could be all of us. I, like many in the financial field, believe that cheap energy will enormously benefit the economy. But our biggest mistakes come from the casual confidence of things we assume to be true but prove not to be. A drop in energy should help the economy, but it doesn’t have to. If people choose not to spend their new energy windfall and save it instead, deflationary pressure will continue to grow. As I’ve previously said, deflation is a real threat that is often overlooked. But even perceived positive forms of deflation, like a significant reduction in the price of oil, can have nasty side effects. The loss to the global economy in terms of the price of oil is only beneficial if that money is spent elsewhere and not saved! For now confidence is that markets will ultimately find the dropping price of oil helpful to global growth, regardless of the early losers in the global price war for oil.

What Investors Should Know After Europe’s Terrible, Horrible, No-Good Month

cartoon spin bull vs bearFalling inflation, terrible economic news and a general sense of dread for the future seems to have once again become the primary descriptive terms for Europe. Earlier this year things seemed to have improved dramatically for the continent. On the back of the German economic engine much of the concern about the EU had been receding. 2013 had been a good year for investors and confidence was returning to the markets. Lending rates were dropping for the “periphery nations” like Portugal, Greece and Ireland, giving them a fighting chance at borrowing at affordable rates. But first came the Ukrainian/Russia problem which caused a great deal of geo-political instability in the markets. Then came October.

I don’t know if Mario Draghi cries himself to sleep some nights, but I wouldn’t blame him. Despite the best efforts of the ECB, Europe looks closer to being in a liquidity trap then ever. Borrowing rates are not just low, they’re negative, with the ECB charging banks to now to deposit money with them. October also ushered in a string of bad news. For Germany, easily the biggest part of the Eurozone’s hopes for an economic recovery, sanctions against Russia have hurt the manufacturing sector. Germany began the month announcing a steep and unexpected decline in manufacturing of 5.7% in August, the biggest since 2009. This news was followed by criticisms of Germany’s government for not doing more infrastructure investment and being too obsessed with their strict budget discipline. Yesterday 25 banks in the Eurozone failed a stress test, a test that was meant to allay fears about the health of the financial sector.

For Europe then things look bad and even if the situation corrects itself over the next few months (sudden shifts in the economy may not always be permanent and can bounce back quickly) the concerns over Europe’s future will likely undermine any efforts by the ECB to properly stimulate the broad economy and encourage investment on a mass scale. By comparison it looks like the United States is having a party.

The US economy seems to be on track to grow, and as the world’s biggest economy (though there is some dispute) the country is fighting fit and especially lean. Cheap oil from shale drilling is helping the manufacturing sector, making the United States more competitive than South Korea, the UK, Germany and Canada, and the sudden drop in the price of oil is a boon to the US consumer to the tune of nearly 50 billion dollars. Consumer confidence is up, as is spending. Debt levels are down, both for companies and households. Most importantly the economy seems to be tipping over into an expansionary phase, with corporations finally starting to put some of their money to work.

Screen Shot 2014-10-28 at 12.22.48 PM

The coming months could be interesting for investors as we return to a time where once again focus is on the US as the world’s primary economy.Screen Shot 2014-10-28 at 12.32.45 PM The concerns of 2008, that the American consumer was done, the country had seen its best days and its corporations would never recover seem far fetched now. Worries over hyper-inflation are as distant as a the never arriving (but inevitable) rate hike from the Federal reserve. Worries about Great Depression levels of unemployment are problems of other nations, not the US with its now enviable 5.9%, now encroaching on full employment. Old villains seem vanquished and even Emerging Markets, long thought to be entering their own golden era, are now taking a back seat to the growing opportunities coming out of the US.

Investors should sit up and take note. It’s possible that the best is still yet to come for the US markets, and if market conditions continue to improve this bull market could prove to be a long one.

The Zombie Apocalypse and Investing

If 2008 was the financial apocalypse it is often written about, it is a zombie apocalypse for sure. It’s victims don’t die, they are merely resurrected as an infected horde threatening to infect the other survivors. And no matter how many times you think the enemy has been slain, it turns out there is always one more in a dark corner ready to jump out and bite you.

This past month has seen the return of the zombie of deflation, a menacing creature that has spread from the worst ravaged economies in Europe into the healthier economies of the Eurozone. Deflation is like the unspoken evil twin that lives in the attic. I’ve yet to meet an analyst, portfolio manager or other financial professional that wants to take the threat seriously and doesn’t insist that inflation, and with it higher interest rates are just around a corner.

The eagerness to shrug-off concerns about deflation may have more to do with the reality that few know what to do when deflation strikes. Keeping deflation away is challenging, but not impossible, and it has been the chief job of the central banks around the world for the last few years. But like any good zombie movie, eventually the defences are overrun and suddenly we are scrambling again against the zombie horde.

This. Except it’s an entire economy and it won’t go away.

In the late 1990s, Japan was hit with deflation, and it stayed in a deflationary funk until recently. That’s nearly 20 years in which the Japanese economy didn’t grow and little could be done to change its fate. The next victim could be Europe, whose official inflation numbers showed a five year low in September of 0.3%. That’s across the Eurozone as a whole. In reality countries like Greece, Spain and Portugal all have negative inflation rates and there is little that can be done about it. Pressure is mounting on Germany to “do more”, but while the German economy has slowed over the past few months it is still a long way from a recession and there is little appetite to boost government spending in Germany to help weaker economies in the EU.

Japanese GDP from 1994-2014
Japanese GDP from 1994-2014

Across the world we see the spectre of zombie deflation. Much has been made of China’s slowing growth numbers, but perhaps more attention should be paid to its official inflation numbers, which now sit below 2% and well below their target of 4%. The United States, the UK, the Eurozone and even Canada are all below their desired rates of inflation and things have gotten worse in this field over the summer.

What makes the parallel between this and a zombie apocalypse so much more convincing is that we have squandered some of our best options and now are left with fewer worse ones. Since 2008 the world hasn’t deleveraged. In fact governments have leveraged up to help indebted private sectors and fight off the effects of the global recession. Much of this come in the form of lower (from already low) interest rates to spur lending. But when the world last faced global deflation the cure ended up being broad based government spending that cumulated in a massive war effort. By comparison the debts of the government haven’t been transformed into lots of major public works initiatives, instead that money has sat in bank accounts and been used for share buybacks and increases in dividends.

For investors this is all very frustrating. The desire to return to normalcy (and fondly remembering the past) is both the hallmark of most zombie films and the wish of almost every person with money in the market. But as The Walking Dead has taught us, this is the new normal, and investing must take that into account. Deflation, which many have assumed just won’t happen, must be treated as a very likely possibility, and that will change the dynamics of opportunities for investment. It leads to lower costs for oil and different pressures for different economies. It will also mean different things for how people use their savings for retirement and how they will seek income in retirement. In short, the next zombie apocalypse can likely be defeated by paying attention and not keeping our fingers in our ears.

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If it were only this simple….

Ninjutsu Economics – Watch the Empty Hand

First, an apology that we have been on a break from our website. Over the last month we’ve had lots going on that has distracted us from doing our regular writing, but we’re back now for the rest of the summer!

Since 2008 there has been two great themes in investing. One, is the search for yield, or income, from safer investments. The second has been the imminent arrival of a rising interest rate environment which threatens to gobble up everyone’s money. If you aren’t too familiar with monetary policy or even how low interest rates work on the economy, don’t worry. What you need to know is this:

In really bad economic times Keynsian theory states that the government should help the economy by creating inflation through stimulus spending and keeping borrowing rates low. This is often done by printing large amounts of money. The availability of cheap money has an inflationary effect on the market, and the economy is believed to rebound more quickly than it would have if it had simply let businesses fail and people be laid off work.

The flip side is that many believe printing money can lead to serious and even extreme hyper-inflation (not entirely unfounded) that in the long term can be extremely detrimental to the financial health of people. This is the fundamental tension in modern economics that is nicely summed up in the below parody video of John Maynard Keynes vs F.A. Hayek. Should markets be steered or set free? Or put more bleakly, should economies be allowed to collapse or should they be saved in the midst of an enormous financial meltdown?

In the past few years there has been an enormous amount of money printing going on (Keynsian) but at the same time governments have been trying to reduce their debts and deficits (Hayek). But the money printing has many people worried. The printing of billions of dollars globally has many inflation hawks declaring that the end of America is nigh, that the currency will soon be worth nothing and that the older traditional economies are doomed to fail. This concern has seeped into the general consciousness to a great degree and it’s not uncommon for me to get questions about whether the United States is on the verge of some new financial collapse.

I tend towards the contrarian angle however, and encourage you to do the same. So much energy and time has been focused on the threat of inflation, few seem to be watching the encroaching danger from deflation.

What’s deflation? It’s like inflation only much worse, since no one knows how to fix it. Deflation is a self fulfilling prophecy where a decreasing supply of circulating money leads to a drop in general prices for everything (this includes labour and products). On the surface that doesn’t sound too bad, but since people tend to earn less in a deflationary environment your existing debt tends to become ever more burdensome. In the same way that the collapse of the American housing market made many homes less valuable than the mortgages on them, deflation just does it to the whole economy. Japan has been in a deflationary situation for nearly 20 years, with little sign of relief. Even last year’s introduction of the unprecedented Abenomics has yet to produce the kind of inflationary turnaround that Japan is in such desperate need of.

When I look to Canada (and more specifically Toronto) I tend to see many of the signs that deflation looms in the shadows. Borrowing rates are incredibly low, largely to encourage spending. Many small retail spaces sit empty, squeezed out by  rising lease costs. Manufacturing sectors in Ontario continue to suffer, while wages remain stagnant. Canadians are currently sitting with record amount of debt and most growth in Canadian net worth have come through housing appreciation, not through greater wealth preservation. In other words, the things that contribute to a healthy economy like rising incomes and a growing industry base are largely absent from our economy. The lesson here is that when it comes to markets, we should worry more about the issues we ignore than the ones we constantly fret over. It’s the hand you don’t watch that deals the surprising blow!

Be the Most Interesting Person at Christmas Dinner

Merry Christmas and Happy Holidays! We’ve been busy over here for the last couple of weeks and unfortunately I haven’t been able to update our blog as often as I would like. However lots of interesting and important things have been happening over the past two weeks and they are worth mentioning. Check them out below!

Bitcoin is maybe not going to survive. Maybe: There is an ongoing fight about whether Bitcoin, the digital currency, is in fact a real currency. Bitcoin has been criticized for being a tool of the criminal underworld, and praised for its inventiveness. But like all fiat currencies there is a lot of speculation about whether it is worth anything. After all, who is backing Bitcoin? There is no government that will guarantee it and not every government is happy with it, and its value fluctuates wildly. And yet Bitcoin persists, at least until today. China has just banned Bitcoin and its largest exchange will not accept any more deposits, sending the value of Bitcoin tumbling.

What’s good for the investor maybe bad for the economy: There is a demographic shift going on in the Western Developed nations. People are getting older. Not just older, but retirement older, and as a result the economy is feeling pressured to respond to needs arising out of this aging baby boomer trend. One of those shifts is towards dividends. Dividends are traditionally issued by companies to their shareholders when the companies have extra money lying around and can’t use it productively. However many companies, especially large ones that generate more cash flow than they can reasonably use issue regular dividends, such as banks and many utilities. This is useful to investors that are looking to retire or are retired already. Regular dividends help provide retirees with regular and predictable income. However dividends may be bad for the economy. CEOs are often rewarded for market performance, and markets tend to like companies that increase their dividends (Microsoft increased its dividend in September). But companies can be far more useful to the economy generally when they invest in growth rather than give money back to shareholders. That would mean hiring new people, building new factories and generally moving money through the economy. But as much of the population ages and looks for dividends this might undermine the both growth in economic terms and affect choices that CEOs make about the future of their companies.

Canadians are at record debt levels, again: This may not come as much of a surprise, but Canadians have record debt levels and nothing seems to be correcting it! This story began regularly occurring in 20102011, 2012, and of course 2013. What is more important about how high the debt of Canadians continues to rise, but what’s driving it. Not surprisingly it’s mortgages. The high cost of Canadian housing has worried the federal government, and many global organizations. But far worse would be a deflationary cycle on Canadian homes, driving down the price while saddling home owners with debts far in excess the value of their houses. Despite a number of efforts to limit the amounts that Canadians are borrowing, the very low interest rate set by the Bank of Canada is keeping Canadian’s interested in buying ever more expensive homes. The reality is that no one is really sure what is to be done, or what the potential fallout might be. What is clear is that this can’t continue forever.

We’re going to be taking next week off, but will be back in January!