To Raise Or Not To Raise, That Is The Question
In less than twenty-four hours, Chairman Janet Yellen of the US Federal Reserve will decide, whether or not, to raise interest rates for the first time since June of 2006. While we certainly appreciate the danger of a prolonged period of negative real rates of interest, we here at Sachem Rock do not think the time to do raise interest rates is right now.
The BRIC countries (Brazil, Russia, India, China) are the world’s largest emerging market economies. Of the four, only India’s recent economic data clearly indicates it remains in expansion. Brazil and Russia, both commodity-driven economies, have endured a sharp decline in commodity export revenues. Ditto for the emerging markets of South Africa, Peru, Columbia, Venezuela, and Malaysia, to name a few. In addition, the commodity export behemoths of Canada and Australia have already slipped into recession, and much of Europe remains an economic basket case.
As the result of “globalization”, the emerging markets now account for 50% of worldwide demand, up substantially from twenty years ago. So the well being of the emerging markets matter more than ever to the health of the worldwide economy.
Over the last year, we have witnessed significant monetary outflows from the emerging markets to developed economies. An increase in US interest rates will likely increase those outflows, by driving the value of the US dollar higher relative to the currencies of emerging market countries. Remember, over the last sixteen months, the US dollar had already risen significantly, relative to the Euro and other emerging market currencies. For the emerging market countries, a higher US dollar will likely result in further increases in import prices and even less purchasing power in the face of dramatically lower export prices. A continued rise in the US dollar could further exacerbate an already challenging economic environment in the emerging markets as many countries have already have low currency reserves, and high levels of sovereign and corporate debt.
This unfolding scenario in the emerging markets, whether or not the Fed raises interest rates, is the essence of our “Bear Market” trepidation. We believe the worldwide equity markets’ concern with the wellbeing of the emerging markets is what caused the sharp sell-off during the month of August, triggered by the “surprise” China currency devaluation.
It is also why we believe that that Chairman Yellen will not raise interest rates on Thursday afternoon. We believe it is the “rational” course of action, however, we do acknowledge the Fed occasionally makes policy mistakes.
So what does the Fed rate decision mean for US and foreign equity markets?
We believe that Wednesday and Thursday market sessions are likely to be low volume and low volatility before the announcement, as the significance of the FOMC (Federal Open Market Committee) meeting has been long communicated by the Fed. The market should continue to trade in a tight range pending the release of the decision on Thursday afternoon.
We also acknowledge this Fed decision may result in a “damned if you do, damned if you don’t” response for worldwide equity markets. Markets may perceive a decision to increase US interest rates as further destabilizing to the emerging markets, rather than “signaling” a Fed’s perception of underlying worldwide economic strength. A decision to forego an increase in US interest rates may be taken by the markets as a sign of “fragility”, and the market may sell-off anyway.
A Fed decision to forego a rate increase could conversely result in a “relief” rally, a powerful move upward, in part aided by “short covering”. But we must ask, will the rally be sustained with the broader indexes less than 10% (approx) off the “high” after a six-year bull market run?
In the end, we do not know. No one knows. Much like Prince Hamlet in Shakespeare’s tragedy.