Economic Update

James Hotchkiss – EVP, Treasurer

August 2015

On August 18, 2015, the market priced in a 54% chance of the Fed raising rates for the first time in a decade. On September 17th most economists, about 80%,  also thought the same. Why? China's stock market recently took a $3.3 trillion loss and devalued their currency – moves that exacerbated market volatile worldwide. The US economy was still trending higher led by a Labor market which was quickly normalizing: the unemployment rate, at 5.3% and falling, reached levels not seen since 2008. Firings, as measured by weekly jobless claims, were bouncing around 40-year lows, job openings were at record highs and quit rates were rising.

Furthermore, persistently low firings combined with a greater demand for workers in an environment with a declining base of skilled workers strongly pointed to higher wages ahead. Higher wages along with rising consumer confidence levels, rising household wealth and rising disposable personal income pointed to a rise in consumer spending. While consumer spending had been surprisingly lackluster, given the huge discretionary windfall from lower fuel costs, the growing strength in spending on large durables like autos and homes plus the strong retail sales data in July suggested households were finally feeling wealthy enough to ramp up spending. This was very encouraging as consumer spending accounts for more than two-thirds of US economic output.

One week later however, the odds of a September Fed firming move dropped appreciably. Even though US economic data continued to strengthen, market rates as of this writing on August 25th are now pricing in at just a 25% chance the Fed moves in September. While most economists, 76%, still believe a move will happen this year, only 37% now think that first move will occur in September.

The immediate cause of the massive sentiment shift and outburst of global volatility was China, where a sharp drop in stocks on Monday, August 24th in China continued a rout that has been underway all summer. The continued rout combined with their recent currency devaluation and less rosy manufacturing data led markets to believe that the Chinese economy may be faltering at a faster pace than China has acknowledged, and more importantly, that the powerful Chinese authorities do not have the capability of stopping the slide.

China's financial woes in turn led to a collapse in commodity prices and a rout of currencies and stocks in emerging markets from Malaysia to Mexico, countries that rely heavily on China for their commodity exports. The collapse in commodity prices in turn fostered slowdown fears in US oil and export sectors and the specter of deflation. This caused a massive flow of funds onto US shores into safe assets such as Treasuries and a flow out of riskier assets such as US stocks.

In the background of all this is the crucial fact that the fear of the Fed raising rates was another major factor. The fear of rising US rates caused upward pressure on the dollar and downward pressure on commodities. These pressures hurt commodity exporters and China's exporters which forced China and all emerging market nations to devalue their currencies to help their faltering export sectors. This in turn caused China's stock market to crumble and led to the world wide rout described above.

China by itself is not a factor relative to US economic growth. Our exports to them account for less than 1% of GDP.  What is a factor is what their slowdown will do to the pace of US inflation. Lower inflation expectations combined with the world wide volatility, if continued; clearly argue for the Fed to not firm in September.

The final argument on the timing of the Fed move is a circular one. Volatility in the markets could make the Fed wary of making a move, which will then continue to artificially prop up stock and commodity markets. But when things calm down and the Fed talks about firming again, be it in December or March 2016, volatility may force the Fed to once again remain on hold – starting the circle again. To end this circle, the Fed needs to begin normalizing rates.

Until then, worldwide markets are being held captive to what the Fed does or does not do, and the Fed is being held captive to the worldwide reaction to what they do or not do.

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