Financial Review

To Hike or Not To Hike

Financial Review by Sinclair Noe for 09-11-2015

 

DOW + 102 = 16,433
SPX + 8 = 1961
NAS + 26 = 4822
10 YR YLD – .04 = 2.18%
OIL – 1.12 = 44.80
GOLD – 3.70 – 1108.20
SILV – .13 = 14.68

 

The S&P 500 index was up 2.1% for the week, the best weekly gains since July.  The Dow was up 2.1% for the week, and the Nasdaq gained 3%.

 

The Senate has blocked an anti-Iran deal resolution. Senate Democrats successfully fended off an effort by the Republican-led Congress to dismantle the Iran deal with a disapproval resolution. While the Senate killing the resolution should mean that Congress’s bid to undo the deal is over, the House is fighting on with several bills aimed at expressing their disapproval. There’s even talk of filing lawsuits against the president.

 

Russia is calling for Washington to restart direct military-to-military cooperation to avert “unintended incidents” near Syria, at a time when U.S. officials say Moscow is building up forces to protect President Bashar al-Assad’s government. The U.S. is leading a campaign of air strikes against ISIS fighters in Syrian air space, and a greater Russian presence would raise the prospect of the Cold War superpower foes encountering each other on the battlefield. Both Moscow and Washington say their enemy is ISIS, but Russia supports the government of Assad, while the U.S. says his presence makes the situation worse.

 

The White House has announced that the U.S. is preparing to accept 10,000 Syrian refugees for the 2016 fiscal year. The Syrian Civil War is now in its fifth year and more than 4 million people have become refugees. Syria’s neighbors currently host the majority of the country’s refugees. As conditions deteriorated, many refugees made the dangerous trip to Europe. European Union governments are likely to agree in principle to shelter 160,000 refugees from crisis zones. To date, the U.S. has resettled less than 1,500 Syrian refugees out of 18,000 referred by the United Nations.

 

A week before the Federal Reserve’s most critical policy decision in years, Wall Street opinion makers can’t agree on anything. Not only is there no consensus about whether the Fed will end its seven-year-old policy of zero interest rates, but views on the fallout from such a move are wildly disparate.  We’ll all find out more on Wednesday, when the FOMC issues its statement. As divided as the market is on that decision, it’s the aftermath that stirs the real split. Many say the economy is too weak for a rate hike, and fear the markets could tank. Others say the rate hike is warranted, even necessary, and would signal the economy is strong.

 

The real question is what will happen when interest rates rise? First up, a rate hike would strengthen the dollar, particularly if the hike is part of a long-term cycle. A stronger dollar would likely result in money flowing into the US. A stronger dollar means assets priced in dollars would go down in price; so we might anticipate weakness in commodities such as oil, industrial metals, and precious metals – pretty much all commodities except agriculture. In this way, a rate rise would be deflationary.

 

A stronger dollar would put even more pressure on emerging market currencies, which have already experienced pressure; there is still plenty of dollar denominated debt in emerging markets. Countries with current account deficits could expect to feel the pressure, led probably by Brazil.

 

For real estate, there is no question that lower interest rates spurred real estate purchasing activity. So, it stands to reason that an increase in rates will have the opposite effect, by reducing demand due to higher costs of money. Some say that a slight rise will cause a short-term increased demand for purchasing real estate; people think that rates will continue to rise, potentially keeping them out of the market in the future, and so they act. The longer-term effect is to tap the brakes on real estate.

 

For stocks on Wall Street, the impact of higher rates is tougher to call. Historically, there is no direct correlation between the start of a rate-rising cycle and a drop in stock prices. The reasoning is that rates are hiked when the economy is strong and the economy is humming along, perhaps humming along a bit too fast. Historically, Wall Street reacts negatively to surprise moves by the Fed (think 1987) but the Fed has been warning they will hike rates and they will do so slowly and incrementally – no surprises, just some guessing about the exact date. Most investors aren’t confident that the economy is strong right now; earnings growth has been flat, stocks have suffered a correction, and there is still slack in the labor market.

 

Ultimately, the stock market will respond to the fixed income and credit markets, and this is pretty straightforward; higher target rates set by the Fed will send bond yields higher, which means bond prices must go down.

 

With yields already low, the proportionate falls in prices need to be that much greater and the biggest price drops will come for the assets with the greatest duration. The twist here is that long duration assets are widely perceived as less risky, because they carry a lower risk of default; for example: corporate bonds, or municipal bonds. Junk bonds carry greater credit risk, and are considered less sensitive to a rise in interest rates.

 

The biggest risk is that markets get panicked. People who think they have a low risk asset suddenly realize they are exposed, and they hit the sell button, which can lead to a herd or mob mentality. If prices go too far south too fast, credit markets can freeze, and when that happens, everything freezes. The gears grind to a halt and the markets crash. There really is no reason to expect a crash. The economy can withstand a little quarter point rate increase. We don’t know what the Fed will announce on Wednesday, but we should not be surprised by a hike.

 

Of course, if you don’t like volatility, you could just stop playing the game for a while. Investors pulled another $19 billion from equity funds over the past week. The exodus from emerging markets also continued, with losses extending into their ninth week. Emerging equity funds shed $4.5 billion, while U.S. equities saw outflows of $15.9 billion and European stocks lost $800 million. Japanese funds were the only category to post inflows. The data also that global equity funds had shed $46 billion over the past four weeks. Year-to-date outflows from emerging stocks total $58 billion.

 

Consumer sentiment declined in September to the lowest level in year as Americans anticipated a weaker economy in face of a global slowdown and turbulent financial markets. The University of Michigan’s preliminary index dropped to 85.7 from 91.9 in August, the largest one-month decline since the end of 2012. Households were less upbeat about future growth in employment and wages than a few months earlier as 73 percent of respondents reported hearing news of negative economic developments.

 

Wholesale prices were flat in August, held down by a sharp decline in gasoline prices. The producer price index was unchanged last month on a seasonally adjusted basis. Excluding the volatile categories of food, energy and trade margins, core producer prices edged up 0.1%. Over the past year overall producer prices have fallen an unadjusted 0.8%, unchanged from July. The core rate has risen 0.7% in the same span.

 

How low can oil go? Goldman Sachs has cut its 2016 forecast to $45 a barrel from $57—and it’s leaving open the possibility that prices could go much lower than that. Goldman says the global surplus of oil is even bigger than previously thought and that could drive prices as low as $20 a barrel. Goldman said in a report e-mailed this morning that it is cutting its Brent and WTI crude forecasts through 2016, in part because a failure to reduce production fast enough may require prices near the $20 level to clear the oversupply. The Goldman report stands in contrast to a report yesterday from the International Energy Agency, estimating that crude stockpiles will diminish in the second half of next year as supply outside OPEC declines by the most since 1992, with drops in U.S. shale production accounting for 80 percent of the decline. The IEA thinks lower supply will support prices. Twenty bucks isn’t Goldman’s most likely scenario but it’s a nice dramatic number that generates lots of tweets, as were the forecasts by Goldman and others in the not-so-distant past that oil would hit $150-$200 a barrel.

 

Copper prices dropped today, ending the metal’s longest rally since June. Copper prices have fallen 15 percent this year amid concerns that slower growth in emerging markets will reduce demand. Tighter U.S. monetary policy could further damp consumption as foreign currencies weaken and make the metal more expensive for overseas buyers. Copper for delivery in three months sank 0.5 percent to settle at $2.43 per pound. Prices climbed in the previous four sessions, rising 5.4 percent on concern that supplies would tighten as miners including Glencore took steps to cut production.

 

Nate Silver from FiveThirtyEight has run the numbers on the 2015 NFL Football season. He figures the season will come down to the Patriots and the Seahawks, and Seattle will win the Super Bowl, even though the Patriots will have win more games – 11.3 to be precise. Silver predicts the Cards will win 8.2 games – not enough to win the division, but more than San Francisco.

 

Arizona state troopers took two people into custody today who they believe might be connected to a string of 11 recent highway shootings. One detainee was described as a “person of interest.” So far, eight vehicles have been hit by bullets while police haven’t specified what hit the other three. This doesn’t mean the cops have caught the shooter or shooters, just that they have someone in custody. Be careful out there.

 

 

 

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