Economic Insights - January 4 - 8, 2016
What Happened to Markets?
It’s angst about China. The Santa Claus rally failed to materialize as Santa left investors only lumps of coal. It was the worst start to a year for the Dow Jones Industrials since records began in 1896. With perspective, it was the 93rd worst of the 6,220 weeks since 1896. The worst was an 18.2% crash the week ending October 10th 2008, small consolation for those smarting from the week’s losses.
Two items: a business survey that showed a tick worse contraction in manufacturing, suggesting the economy was still sinking; second, the central bank set a currency fix versus the U.S. dollar that was much weaker than expected. The selling started on Monday’s open. Adding pressure was anticipatory selling as policymakers planned to end the ban on sales by large stockholders. Also on Monday, regulators implemented so-called circuit breakers for the first time, i.e., a 15-minute market closure if selling reached panic levels of down 5% on the Shanghai Composite. But, after the first pause on Monday, the selling intensified and shortly hit the second circuit breaker, a 7% total plunge, closing markets for the day.
The central bank set the currency fix even lower on Wednesday and Thursday and local traders needed only 29 minutes to push the stock market through both pause-points and close once again. At a hasty meeting called after the Thursday collapse, regulators ended the new circuit-breaker plan and left the selling embargo in place. Calm reappeared on Friday as the currency fix was set a tad stronger.
Currency, The Real Problem:
The global contagion from the machinations in China was over prospects for the currency. Stock market gyrations are not so relevant except insofar as a collapse fosters more outflows. Investors could not know what was happening, but there were two possibilities, both ugly: first, China was intentionally weakening its currency to perk up its depressed, overbuilt manufacturing sector and a massive devaluation was coming. Second, China had lost control of its currency as millions of investors tried to get their funds out of the country and a huge involuntary devaluation was coming. After all, China’s reserves plummeted $108.3 billion in December and over $500 billion in all of 2015 as the central bank tried to support the currency. Whether voluntary or not, a large devaluation by China would spread brutal deflation around the world, pull in jobs and growth from other countries, foster meaningful declines in equity markets, and likely bring retaliatory trade barriers from other countries, crushing international commerce. Markets plunged on these revolting prospects and uncertainties.
A Positive Spin:
One can paint a much less negative picture of both the stock market plunge and the weak yuan/dollar fixing. First, the stock market perspective: regulators were planning to end the prohibition against sales by large stockholders; all investors knew that and tried to get out before those sales. Further, the new circuit breakers caused investors to rush to sell ahead of any market closing. So, much of the selling pressure was from poorly designed or miscommunicated regulation. Now, regulations have changed, the ban on selling was extended, the circuit breaker plan ended, so calm has returned.
Now, the currency: the central bank announced in December it would follow a basket of currencies rather than merely peg the yuan to the U.S. dollar. Calculated versus the basket, the yuan has been mostly stable for several weeks. The dollar is only a quarter or so of the new basket. Since the dollar appreciated against other currencies in the basket recently, the yuan/dollar price had to weaken for the yuan to remain stable versus the basket. So, the central bank is still in control and this week’s drop in the yuan/dollar has no meaning beyond a change in the peg. No harm, no foul.
Ugly Stories Need More Evidence:
Markets didn’t believe the positive spin; investors focused only on the dreaded potential for a sizeable drop in the yuan, whether voluntary or not, and not the odds that it was all a misunderstanding. We don’t think the evidence for either ugly story is very strong as yet. Why? First, the central bank made clear in December it was not willing to follow the U.S. dollar higher anymore, especially through a Fed tightening cycle. So, some weakening against the dollar as it rose versus the other currencies in China’s basket was natural, expected. Second, China has already spent hundreds of billions of dollars of its reserves to stabilize the yuan. China needs a steady currency to prevent more large outflows and not make it more difficult to repay dollar-denominated debt. Policymakers also know a strong currency will ease the transition to a consumer and service-oriented economy, a highly desired outcome.
Thus, we don’t necessarily think a big devaluation is coming (whether intentional or not). Evidence to the contrary would be a persistent weakening of the yuan versus the new basket, which hasn’t happened yet. If it does, even at a slow pace, then it’s time to worry. The market turmoil this week does show the risks in other emerging markets as well as China as they all deal with the aftermath of the 15-year boom driven by China’s surge in investment. And if China tries to ease policy much more to support the economy, it will become even harder to keep a stable currency. But, unless the turbulence continues and the above evidence starts to mount, we’ll call this just another market correction.
So, What's a Girl To Do?
That’s the key question for investors: how to react to the turmoil and the answer depends on what is driving it. Besides the havoc in currency and stocks, oil prices plunged to new lows, now the lowest since December 2003. So, once again, it’s a question that’s been asked for months: is oil nose-diving because demand is caving in as growth craters in China, the United States, and the Eurozone? Or is it an oversupply issue as Saudi Arabia refuses to give up market share and shale oil companies produce from existing wells where variable costs are less than the price?
We believe it’s the latter; oil demand is still rising, the issue remains too much supply and the plunge in gas prices will boost growth. If the market turbulence and oil price collapse meant that a U.S. recession was imminent, one wouldn’t expect the nearly 300,000 job gain in December. Any uplift from cheap gas has been very slow to surface while the negative impact on the energy sector and capital spending from the crash in oil has been obvious for months. The former always comes with a lag, but it’s coming.
Actual Job Growth Awaiting Actual Inflation
The U.S. payroll report for December was simply outstanding, up 292,000 jobs with another 50,000 in upward revisions to November and October. The unemployment rate ticked down a few hundredths but rounded to an unchanged 5%. The labor force expanded significantly as more workers entered from outside and more of those reported wanting jobs. The labor force participation rate edged higher to 62.6% as did the employment to population ratio to 59.5%. All this shows rising confidence in the labor market. The number of people working part-time because they couldn’t find a full-time job fell by 63,000 and the total number of full-time jobs hit a new all-time record for the first time. Overall, 2.65 million more people were on payrolls at the end of 2015 than at the beginning, the second best job growth since 1999.
One negative was a penny drop in average hourly earnings from last month’s cycle high. Still, on a three-month smoothed basis, earnings are up 2.4% over the prior year, a high for this expansion. We expect moderate wage growth as 2016 progresses. Most data series that track wages already show acceleration and the payroll wage data should catch up soon.
The Fed Wants Actual Inflation:
The Fed started its monetary transition, so markets turned attention to the pace of rate hikes. The minutes of the last meeting noted several reasons why that tempo would be gradual. One implication was a desire to see actual inflation show up in the numbers rather than going by staff projections.
The excellent payroll report suggested that the Fed was correct in hiking rates. But, the tick down in average hourly earnings point to slow tightening. The median expectation by meeting participants was four rate hikes this year and that consensus was validated in a recent discussion by Fed Vice Chair Fischer who said four hikes was the most likely path. We believe the path will be slower than that as wage gains are still modest. The Fed will likely let the job market run a bit hot to ensure inflation will head toward its 2% target. So, two or three rate hikes in 2016 seem the most probable.