FOR MARKETS, IT´S THE TREACHEROUS SEASON / BARRON´S MAGAZINE

Up and Down Wall Street

For Markets, It’s the Treacherous Season

Despite the Fed’s decision to delay raising interest rates, stocks and commodities swoon at week’s end. Shades of past market crashes, Long Term Capital Management’s fall, and the Panic of 1873.

By Randall W. Forsyth       

 

 

It’s the most awful time of the year.

One wouldn’t think that, not around these parts anyway. The weather is just right, with warm days and cooler nights; the water is delightful, and the kids are back in school. Sports fans rejoice as the football season is under way, and baseball’s pennant races are reaching their climaxes. What could be better?

For investors, what could be worse? Whether owing to some cosmic correlation or mere coincidence, financial markets seem to be roiled in the days and weeks leading up to and following the autumnal equinox.
 
Many hypotheses have been proffered. Among them from various eras: the return of the bosses from holidays in the Hamptons, who find business has fallen off in their absence, resulting in their slashing payrolls and purchases; the movement of cash from city to country banks to pay for crops back when agriculture dominated the U.S. economy; and even the effect of lunar and planetary movements on the human brain as the seasons change.

Yes, I’ve heard them all.

For whatever reason, a strange confluence of bad things seems to happen at this time of year.

As I’ve noted previously, on Barrons.com (“It’s the First Day of Fall—in More Ways than One,” Sept. 22, 2009), there have been an unusual number of market upheavals around this time. A partial list includes a panic that shut the New York Stock Exchange in 1873; Britain’s exit from the gold standard in 1931; and the Plaza Accord in 1985, which led to the attempt to stabilize exchange rates, which came unraveled two years later and, in turn, led to the October 1987 crash.

Other early-fall market plunges occurred in 1978 and 1979, along with the Long-Term Capital Management–related plunge in 1998. And the crash of 1929 and the financial crisis of 2008 are major events, not just in market lore, but in the nation’s history, as well.

Given this treacherous season, it’s perhaps not so surprising that global stock markets once again were in full swan-dive mode at the end of last week. Yet, more than the time of the year appears to have caused equities to retreat.

On form, stocks ought to have been rallying on the seemingly bullish news that the Federal Reserve decided not to initiate the liftoff in interest rates. The continuation of the near-zero rate policy put in place in December 2008, during the darkest days of the financial crisis, should have been good news for risky assets, whose values have been boosted by investors’ flocking after anything, which is better than the nothing that they get on their cash.

Still, the stock market’s response—surrendering initial gains on Thursday afternoon in the U.S. after the Fed’s stand-pat announcement and plunging worldwide on Friday—suggests that investors sense something less than salubrious in the actions of Fed Chair Janet Yellen and her cohort on the Federal Open Market Committee.

In point of fact, despite the near 300-point, or 1.7%, plunge on Friday in the Dow Jones Industrial Average and the 1.6% drop in the Standard & Poor’s 500, U.S. equity markets fared less badly than other bourses. Germany plunged 3.1% and Japan, 2%. And developing markets also took it on the chin, with the iShares MSCI Emerging MarketsEEM in Your Value Your Change Short position exchange-traded fund (ticker: EEM) off 1.9% on Friday.

The FOMC’s policy statement explicitly noted the pressures being felt from abroad, even as the domestic economy chugs along and the labor market is approaching full employment (at least according to conventional measures). “Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term,” according to the policy-setting panel’s statement.

Many observers were actually shocked, shocked!!! by the FOMC’s recognition of overseas influences in its deliberations. Readers of this space, however, have been beaten about the head over the importance of global influences. “The world is too much with us,” as this column channeled Wordsworth a month ago (“Submerging Markets,” Aug. 24).

Far from being cheered that the proverbial punch bowl is being refilled by the Federal Reserve, markets seem more concerned that the party is winding down. In commodities, crude oil’s bounce was reversed, while copper fell anew on Friday, both signs of subdued animal spirits, to use Keynes’ description.

It should be noted that there was a dissent in the FOMC’s decision to hold rates steady, from Jeffrey Lacker, president of the Richmond Fed, who preferred an immediate increase. But, in a curious footnote, at least one unnamed Fed official called for further easing—to lower the federal-funds target to below zero percent. That was indicated by the dot-plot graph of guesstimates from the various Fed governors and district presidents.

While negative-rate targets have been adopted by central banks abroad, that’s not about to happen here. The Fed’s words and dot plots still indicate the next move will be to raise the rate target from just over zero, not lower it further.

Moreover, negative interest rates have been resorted to by the European Central Bank to deal with average unemployment rates in double digits and far higher rates in Spain and Italy, let alone Greece. In contrast, the headline jobless rate last month was 5.1% in the U.S., a hair above what the FOMC sees as full employment.

Yellen did aver in her post-FOMC news conference that the main unemployment measure does understate the slack in the labor market. But even so, job prospects in the U.S. are better than in most of Europe, where there are officially mandated negative interest rates.

So it’s curious that short-term Treasury-bill rates dipped below zero at week’s end during the global stock market rout and renewed slide in commodities. Some folks are so querulous as to be willing to pay Uncle Sam to hold their money; that’s what negative interest rates mean. And, as a reminder, the Fed pays banks 25 basis points (a quarter percentage point) to park their dough with it—lots more than you or I get in our money-market accounts.

All of which bespeaks tremendous nervousness in the markets. Perversely, the Fed might have fed the disquiet by recognizing the weakness in global markets, notably China, which has been a recurring theme here. The ostrich strategy is an alternative, to be sure, but not one that provides real protection.

In the best of circumstances, the central bank’s policy decisions might be just a matter of timing. To reiterate the point about rate hikes made at the Federal Reserve’s Jackson Hole confab last month by Raghuram Rajan, the head of India's central bank, “My position over time has been, don’t do it when the world is in turmoil.…It’s a long-anticipated event; it has to happen sometime, everybody knows that, but pick your time.”

Now isn’t the time. The reason for that extends beyond the plunge in stocks in China, as implied by the global selloff in equities and commodities and the dip into negative territory by T-bill rates. The markets sense something, and it’s not just the date on the calendar.

THE OTHER PUZZLING ASPECT of the Fed’s nondecision decision is: How could a measly quarter-point hike in short-term interest rates mean so much? It may have been more because the FOMC lowered its median rate guesstimates for the end of 2016 and 2017 by about a quarter percentage point, to 1.5% and 2.5%, respectively.

For what it’s worth, the FOMC also projected a fed-funds rate around 3.5% by the end of 2018, roughly in line with what participants think is the long-run equilibrium. Given the uncertainty about the next three months, however, forecasts for three years should be taken with a hefty chunk of salt. The key message is lower rates, for longer.

But that isn’t the whole story. With interest rates in most advanced countries near zero, currency exchange rates arguably are more important influences on their economies. By holding rates near zero, Yellen sends an implicit message that the U.S. central bank doesn’t want the dollar to rise further and exert further restraint.

A strong buck also weighs on the prices of commodities, including oil. And that has translated into credit problems.

As The Wall Street Journal reported on Friday, defaults among leveraged oil producers are on the rise. That is the main— but not the only—area of strain in the junk-bond market. In the emerging markets, a further rise in the greenback also would boost the burden of companies’ dollar-denominated debt.

Inflation-phobes fear that maintaining near-zero interest rates will push up prices, in a rerun of the 1970s.

But in the 21st century, cheap money has mainly boosted asset values. The Fed reported on Friday that households’ net worth rose to a record $85.7 trillion in the second quarter, a 0.8% increase from the level three months earlier. The bulk of that gain was in the value of residential real estate.

A modest proposal: Maintain zero interest rates to produce a bubble and then an oversupply in rental properties, to help house the millennials who might finally move out of their parents’ basements to sign leases on affordable digs of their own. Cheap credit brought us low-cost gasoline. It could do the same for flats.