As a global markets observer and commentator, I always try to comment on the issues and developments that investors care about. Today, the two things they care about most are China and oil. The majority of investors believe that if we somehow could unlock the mystery of these two market drivers, investors’ game plan for the year would be self-evident.
To be fair, China and oil surely are the two most observable drivers at present. From the perspective of market participants, China is the newest source of crisis – the new “subprime” if you will – and oil prices are not far behind. Every day there is a bit of volatility it is usually because the Chinese have done or said something, or oil is making a new 10-year low after having made a new low the day before.
In my view, however, while China and oil are the two most observable market drivers, they are the symptoms, not the root cause, of the market volatility. And if we are to have the correct read on the markets, focusing on the root cause, rather than the symptoms, is critical.
The Chinese economy has been slowing since 2011 and the financial markets did just fine for a while. Given China’s high savings rate, large reserve base and substantial momentum in the consumer economy, we all assumed that China’s policymakers had the levers needed to transition to a more consumer/service oriented economy and everything would be all right.
So, what changed?
U.S. Federal Reserve (Fed) policies.
How Fed Policies Affect China
Only when the Fed started talking about raising U.S. interest rates and the dollar strengthened did things change radically. The appreciation of the dollar, and the renminbi peg to the dollar, has caused all manner of trouble in China.
Chinese policymakers pumped liquidity to maintain the dollar peg and ensure that a slowing domestic economy didn’t slow even more. That led to an equity price bubble. When that bubble started bursting, their interventions in the equity and foreign exchange markets became textbook cases on what happens when policymakers act without thinking through all the potential consequences.
The bottom line is that the strength of the dollar due to Fed tightening and the prospect of more interest rate hikes to come, combined with the dollarized culture of business and speculation in China, caused massive capital outflows in China and every other emerging market, a trend that persists to this day. Absent these outflows, it was likely that, slowly but surely, China would transition to a more consumer-driven economy. The outflows, and the ham-handed way in which Chinese policymakers are dealing with them, are now the cause of volatility in all capital markets.
China, in my view, has the policy tools and the financial wherewithal to deal with this transition. However, Fed tightening in the midst of this transition is causing capital flight. That, in turn, increases the potential for a policy accident in China. I still believe China ultimately will be successful in making that transition to a consumer-driven economy, but it is becoming quite clear that the capital markets will probably be far more volatile through that transition.
Strengthening Dollar, Weakening Oil Prices
The story with oil is not that different. Again, Fed tightening and the consequent strength of the dollar resulted in capital outflows from China and other emerging markets. That led to slowdowns in those countries at the same time massive oil supplies were coming online to meet the expected demand in those countries. When the slowdowns came, demand for crude oil declined, causing supplies to spike and prices to plunge.
That is true of oil and also of virtually every other commodity. The fact that most of the commodity trade in the world, and a substantial amount of cross-national corporate borrowings, is dollar denominated, certainly has not helped the markets. The results have been increased investor consternation and global market volatility.
In other words, after the financial crisis of 2008, the Fed was the primary source of liquidity in the world, but as the Fed begins to reverse that role, the resulting capital flows out of the emerging world have become the root cause of market volatility.
When the Volatility Will End
If you accept the hypothesis that the root cause of all evil (volatility) in today’s markets is the Fed’s decision to begin raising interest rates, then what does it all mean?
To me, the answer is relatively straight forward: In a still deleveraging world, market volatility will remain high until the Fed stops tightening. Put another way, it isn’t China’s economic growth or plummeting oil prices that matter in the end. Those are just mere symptoms. Fed tightening is really the driver of it all.
If you hope to predict when the markets will reverse themselves and volatility will subside, figure out when the Fed will stop tightening. That is what I am focused on.
In my view, given the current employment momentum in the U.S. economy, the Fed does not get off the current tightening path until the second quarter of 2016 at the earliest. More likely it will be in the second half of the year. Until then, volatility rules.
As a long term investor, I would take advantage of the volatility to buy good assets. That being said, some would argue, as my colleague Mark Hamilton, Chief Investment Officer, Asset Allocation, does, that a defensive tactical approach for the interim may be worth considering while we wait for the Fed to turn.
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These views represent the opinions of OppenheimerFunds and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the publication date, and are subject to change based on subsequent developments.