December 16, 2015 will go down as one of the most important days in financial history. It’s the day the Fed finally put an end to ZIRP and told the markets that they believe in the U.S. economy. I give a lot of credit to the Fed for making this unprecedented and historic move in light of all the public pressure from people saying that they shouldn’t. I mean here we have a room full of academics that were charged with having to make the largest risk decision of the 21st century. The Fed did this with such a chorus of voices ranging from economists to strategists to portfolio managers to journalists all putting in their opinion as to why the Fed should not raise rates and the catastrophic events it could cause if they did. But the Fed finally stayed true to their mandates, pulled the trigger, and lo and behold the markets didn’t implode and the sun still came up the next day. Now granted, all those good feelings faded by early Thursday as equities tanked on the back of oil getting crushed again, but that’s just business as usual. The selloff continued into Friday as oil and high yield credit contagion fears roiled markets, but Fed liftoff was not to blame.
So now that we can take the jump risk of moving from ZIRP off the table, we can reassess the current market environment and try and figure out where things are headed. The main issue confronting markets now is the collapse in oil and the rest of the energy complex. It’s safe to say that because of fracking, oil will not be headed higher anytime soon. If anything, oil will drift lower as we have OPEC, Russia and other energy export dependent countries that will continue to sell oil to fund their budgets. Any decent bid to oil will be met with increased supply from the U.S. I firmly believe that low oil benefits far more people than it hurts and will continue to be a benefit to developed markets. For now though, we are stuck in a negative feedback loop where the lower oil goes, the more the stock market sells off based on potential credit defaults throughout the U.S. energy sector. This broad based selloff is understandable for a little while, but soon the market will figure out who the winners are and who the losers will be. Already, investors are sifting through the high yield rubble to find unfairly beat up credits. The fact is, energy only makes up about 15% of the HY market and price levels will eventually reflect that. So for those of us who believe in the rest of the economy, now is a great time to take advantage of depressed prices brought about by fear and the forced selling of some investors.
After energy and domestic credit markets, we have a rather nebulous risk stemming from emerging markets. Many EM’s were dependent on the export of various raw commodities to China and the sale of petroleum products. Adding to that, USD strength is making dollar denominated EM debt that much more difficult to payback. So with the slowdown in China and the collapse in oil, it’s clear that EM is in trouble. What’s not clear, is how much the dollar will rise and will the major risk in EM, Brazil, pull itself together. At this point, both of these items are not known with any kind of certainty. That said, we have to factor in regulation which exists today that takes a lot of risk out of an EM crisis.
Because of the financial crisis of 2007/08, the government determined that the self-regulating component of Wall Street was absent and that something needed to be put in place to do the job. So now, thanks to the Volcker rules, we can be sure that banks don’t have any significant direct/proprietary exposure to EM debt. The downside, however, is that it’s these same rules which are creating extra volatility in equity and fixed income markets through the resulting reduced liquidity of sell side desks. The bottom line here is that I don’t think we are going to have a Lehman type moment because of EM (barring some 10 sigma event!). Now there are large asset managers out there with some EM risk, but that’s manageable…We hope. All this being said, I can’t justify shedding U.S. risk exposure based on EM fears.
Getting back to the more direct impact data, we did get some news last week which troubled me a tad…No, it wasn’t the downbeat manufacturing data, since we know the U.S. economy is all about services!! The bad news was the Markit Flash Services PMI for December which moved down to 53.7 from 56.5. Since 53.7 is still well in expansionary territory, there is no cause for immediate concern. However, if we drift lower again next month and get close to 50, I will be concerned. What’s interesting to note here is that in both the Markit survey and the Philly Fed survey, the employment components both ticked up. Really, at the end of the day, it’s all about jobs. Weekly unemployment claims from Thursday resumed their downward trend going back to levels last seen in 2000. We also got solid earnings out of Lennar and Darden Restaurants attesting to the strength of housing and consumption. This weekend we had the new Star Wars movie come out and set a record for ticket sales at $238 million so far, which is certainly nice to see as people are still spending on top of money already spent on Christmas presents. And speaking of presents, my grassroots research this weekend of seeing packed mall parking lots back home in Amherst, Mass and people tweeting similar stories from around the country tells me holiday sales will be stronger than expected. The moral of the story here is that we’re setting up for a good 2016. The fact that even the Eurozone Flash PMI just finished its best quarter in four and a half years, tells me the tide has finally turned for Europe. So with the continued tailwind of low energy prices and a strong labor market, I see healthy consumption continuing into 2016. In other words, buy the dips is still in effect.
Have a happy and healthy holidays!!!