Is the U.S. economy heading for a repeat of 1938?
The global economy has emerged from a historic crisis and now looks to be on relatively solid ground. Massive government stimulus and record-low interest rates in the immediate aftermath of the crisis have helped rekindle growth and reduce historic levels of unemployment. However, due to psychological scars from the crisis, households and businesses have become more risk averse, using cheap money to pay down debt and repair balance sheets rather than for spending and investment. Inflation and growth are steady, but subdued. The relative health of the economy and recovery in financial markets has caused the government to forego additional fiscal stimulus and led the Federal Reserve to begin tightening monetary policy.
Are we talking about 2016, or 1937?
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This week a Morgan Stanley global strategy team became the latest party to warn about the parallels between the present economic environment and one that followed the Great Depression. In 1938 central bankers hastily raised interest rates in amid a fragile recovery, leading to a double dip recession and causing the Dow to lose around half its value.
As the current Federal Open Market Committee (FOMC) has embarked on a path of monetary tightening, prominent investors have cautioned about the perils of moving too fast. Last March Bridgewater’s Ray Dalio warned the Fed against repeating the mistakes of 1937, but in December Chairwoman Janet Yellen & Co. moved forward with a December hike anyway.
After a raft of better-than-expected economic data early in the year, the Fed began priming the market for a second hike this summer. But after May’s dismal job gains, the Fed decided unanimously this week not only to keep interest rates steady at its June meeting (as expected), but to rethink the pace of future rate hikes. The FOMC dialed back both its short- and long-term interest rate projections, with the (still ambitious) median estimate of interest rates by the end of 2018 falling from 3% to 2.4%. At the March meeting, seven of 17 officials envisioned three or more rate hikes this year while only one expected a single hike. Now only two officials expect three or more hikes while six expect only one hike.
The market sees the possibility of any hike at all this year as a coin flip. In her post-decision statement, Chairwoman Yellen said, “The labor market appears to have slowed down, and we need to assure ourselves that the underlying momentum in the economy has not diminished.” She will comment further in Congressional testimony this week. Former Minnesota Fed President Narayana Kacherlakota thinks the FOMC should instead be thinking about cutting rates. The Fed’s manic communication is making bond traders anxious and contributing to volatility.
Rather than rallying on the Fed’s dovish turnabout, risk assets declined modestly following the rate decision while investors seized on the Fed’s ominous tone in flocking to safe havens. Yield on the U.S. 10-year treasury fell to 1.53% Thursday, its lowest level since 2012, before recovering to 1.61% Friday as equities rallied from oversold levels. The 10-year German bund also joined the negative interest rate club for the first time ever. The European Central Bank (ECB) boosted continental fixed income markets by surpassing expectations with its first round of corporate-bond purchases. Markets believe there is a strong chance the ECB could cut rates further in 2016, despite President Mario Draghi’s hawkish communication about further easing after delivering a larger-than-expected stimulus package in March. Money also flowed into the Japanese yen, further complicating the Bank of Japan’s (BoJ) mission to devalue its way out of deflation.
Also echoing early-to-mid 20th century sentiments, a rise in nationalism could make mutually beneficial global economic coordination more challenging going forward. Contributing to the risk-off sentiment of the week were rising expectations for a British exit from the European Union, or “Brexit.” The British pound fell to multi-month lows as five polls from four different companies showed the “Leave” campaign surging ahead. The Sun, which has the largest circulation of any British newspaper and a history of backing victorious election campaigns, also came out in favor of a “Brexit.” Campaign rhetoric has grown more hostile as the June 23rd vote draws nearer, with the two sides waging a farcical naval battle on the River Thames in London this week.
Moreover, the gruesome murder of British Member of Parliament (MP) Jo Cox sent shockwaves through a country unaccustomed to gun violence and triggered calls for a suspension of “Brexit” campaigning. Cox, an outspoken voice in the “Remain” camp, was allegedly targeted by a far-right “Leave” advocate who eyewitnesses claim yelled “Britain First” after shooting and stabbing the well-regarded lawmaker. Analysts believe her death could swing public opinion of undecided voters back toward the “Remain” camp, with “Leave” campaigners now being painted as dangerous extremists.
British banks are preparing for a potential “Brexit” by borrowing as U.K. Chancellor of the Exchequer George Osborne warned that leaving the E.U. could spark a fiscal crisis. KBW estimates a “Brexit” could hurt large U.S. banks’ 2016 earnings by 1-6%. Barclays analyst Marvin Barth believes "The precedent of a member state leaving the [European] union would open Pandora's box,” causing political movements in eurozone countries to begin more aggressively pushing for an EU exit, which would revive 'redenomination risk'.
Fed officials are known to be keen observers of history, with Ben Bernanke closely studying the Great Depression throughout his career. If Yellen shares his zest for history, her committee will likely continue to err on the side of caution.
China rejected again from MSCI index
The third time was supposed to be the charm for Chinese stocks, with Beijing expecting Tuesday to see the country’s mainland-listed A-shares included in MSCI’s benchmark $1.5 trillion Emerging Markets Index. In fact days before the announcement, a Chinese securities regulator said the inclusion of yuan-denominated A-shares in the index was a “historical certainty.” However, lingering concerns about capital controls and shareholder rights caused the MSCI to once again rebuff Chinese stocks in a blow to President Xi Jinping’s efforts to usher in reform while maintaining stability. MSCI said China must improve accessibility and transparency of it’s A-shares market before being included in the index, with global investors still anxious about putting their money into Chinese markets after the governments heavy-handed intervention to calm volatility last year.
Inclusion in the index would have caused Chinese stocks to benefit from passive inflows into the leading emerging markets index, sparing the government some expense in its bid to prop up markets while the debt-ridden economy goes through a painful deleveraging. Instead, the decision sent the yuan tumbling to five-year lows against the dollar, although the currency quickly rebounded amid perceived government intervention.
Chinese bank representatives have noted an uptick of demand for foreign currencies, but Chinese citizens are still restricted to the conversion of $50,000 per year. Scotiabank, Natixis SA and Royal Bank of Canada believe a record 243% increase in shipments from Hong Kong to China last month suggests companies are using the over-invoicing of imports to covertly increase outflows. In a bid to raise dollars and smooth the yuan’s depreciation, China is now aggressively dumping U.S. equities in addition to paring its U.S. treasury holdings.
Microsoft adds to its professional network
Microsoft (MSFT) announced this week it was buying LinkedIn (LNKD) for $26.2 billion, the $196-per-share deal representing a 50% premium above the social network’s most recent closing price. Microsoft CEO Satya Nadella hailed the coming together of “the leading professional cloud and the leading professional network,” while founder Bill Gates also praised the deal, believing it will make LinkedIn the “Facebook for careers.”
Others, however, believe Microsoft may have paid too steep a price. At 79 times earnings, the acquisition is the richest-ever all-cash internet deal, harkening back to valuations of the tech boom. While LinkedIn stock traded near the purchase price less than a year ago, it’s inability to meet heightened revenue expectations and a compression of multiples within the industry make it a steep hill to climb for the deal to pay off.
Nadella insists the company will not meddle too deeply in LinkedIn’s operations, hoping to avoid the clumsy integration characterizing many previous Microsoft acquisitions.
The deal also solves a growing talent-retention problem for LinkedIn, which relied heavily on stock-based compensation for its employees.
Nadella has effectively re-energized Microsoft, a legacy-bound tech monolith that, prior to his appointment as CEO, had struggled to adjust to an increasingly mobile-centric environment. The success of this acquisition will depend on his ability to do the same with LinkedIn, which is often viewed as the social networking world’s annoying, career-obsessed brother-in-law.
Uber enjoying private life
Uber CEO Travis Kalanick has hinted at the idea the company may be able to meet its ambitious growth goals without having to go public. To do that, it would need to raise unprecedented amounts of private capital. Well, fresh off a $5 billion funding round that included a $3.5 billion direct investment from Saudi Arabia, the company is going back to the well in the form of a $1-2 billion leveraged loan. The capital raise would take Uber’s war chest to around $15 billion. The expected interest rate of 4-4.5% would have a couple of decades ago represented returns from safe-haven sovereign bonds, rather than loans to an unprofitable startup.
Perhaps the company simply wanted to send a response to its Chinese ride-sharing rival Didi Chuxing, which just completed a $7.5 billion funding round.
Acclaimed venture capital investor Marc Andreessen, however, believes an increasing number of tech startups could be eyeing IPOs as the cycle nears an end.
Supreme Court decision a blow to Puerto Rico
The U.S. Supreme Court rejected a Puerto Rican law that would have allowed the commonwealth’s public utilities to restructure some $20 billion in debt. Puerto Rico’s judicial loss is bondholders’ gain with Congress now holding all the keys in the effort to rehabilitate the island’s economy. The decision affirms that Puerto Rico really is a modern-day U.S. colony.
Argentina inflation reporting resumes
Argentina resumed reporting of the Consumer Price Index (CPI) for the first time since December, revealing prices rose 4.2% in May. The index’s reporting was halted in Decemberby new President Mauricio Macro amid allegations it had become the victim of government corruption. Speaking of corruption, a former Kirchner official was arrested after trying to bury cash near a convent.
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