January 11, 2016 Patrick Oliver-Kelley

us economy shrinking

Global economic growth disappointed once again because of the poor performance by emerging economies. Exotic assets did badly, showing a negative 17% return. Latin America dropped 32%. High yield bonds also lost money. Commodities fell by 26%. Euro-zone and Japanese were better off, in local currencies, but against the dollar, they also suffered. Corporate profits are likely to have fallen 3.5%. Investors are cautious about 2016 because China’s economy is the biggest cause of concern.

US Zone

The Federal Reserve hiked interest rates between 0.25 and 0.50 percent while openly allowing that it is up to the market to make the increase stick. This is first rise in nearly a decade, signaling faith that the U.S. economy had largely overcome the wounds of the 2007-2009 financial crises. The Fed confidently considers the labor market improved and inflation will rise to its 2 percent objective. This was a tentative beginning to a gradual tightening cycle and will be carefully monitored.

The median projected target interest rate for 2016 remained 1.375 percent, implying four quarter-point rate hikes next year.

The impact on business and household borrowing costs is unclear. One of the issues policymakers will watch closely in coming days is how long-term mortgage rates, consumer loans and other forms of credit react to a rate hike meant not to slow an economic recovery, but nurse monetary policy back to a more normal footing.
Growth in total business fixed investment has slowed, mainly because of the dramatic fall in oil prices and plunge in fracking and related investments.  In the US, the economic distress in the “oil patch” is offset by the huge benefits to the rest of the country from lower fuel prices.  But among OPEC and other oil producers, the setbacks are liable to have serious political as well as economic repercussions.  In recent years, much has been accomplished in the US to deal with the “too big to fail” dilemma.  Most large banks and other significant financial institutions have shrunk and will shrink further, while their equity positions have strengthened and continues so.  Their retreat from the credit market has created space for nonbank institutions to grow, especially in the making and packaging of loans, many of which are commodity-based.  The resulting hedge funds, private equity partnerships, internet lenders, and so on, are owned by (mostly) rich people who have skin in the game.  So they have greater incentive and are better equipped to avoid losses.  But these sophisticated investors also are more likely than holders of mutual funds or bank deposits to withdraw funds or hedge their positions when markets turn turbulent.  In sum, nonbanks, like banks, are also subject to runs that can become infectious, resembling what happened in 2008.  And such spasms, as recent experience demonstrates, are more prevalent in high-frequency trading markets.

you're fired

While individual investors and taxpayers are better sheltered than before, the macro-economy may be at greater risk.  Should there be a financial embolism, the Federal Reserve’s power to intervene has recently been curtailed by new rules linked to the Dodd-Frank overhaul, and the willingness of Congress to authorize fiscal assistance to financiers is probably lower than ever.

Euro Zone

Although Europe may benefit from lower fuel prices, the outlook there is especially grim. Local chauvinism, inflamed by huge immigration from culturally non-Western areas, is superimposed on deeper problems of population aging and decline.  (In notable contrast with many other industrial countries facing similar demographic problems, the new Japanese budget includes funds for child nurseries and senior service centers, in the hope this will permit adult relatives to remain at work.)  The greater exchange-rate uncertainty introduced by last week’s events — a falling euro has been the main channel through which the ECB’s policies were supporting the euro zone economy — will further dampens private investment plans.  The same probably holds true for longer-range investment plans by US firms, many of which are, or wish to be, multi-national.  More broadly, the political stability, personal safety, and orderly financial environments needed to promote long-term investment are under assault in much of the world including, albeit to a lesser extent, the US.

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