While the U.S. economy thrives and is likely to grow even faster in 2015, the disarray elsewhere in the world has caused the U.S. equity markets to pause (“dip,” if you will). The immediate cause is the rapid fall in the price of oil and the possible fallout for foreign political, economic and financial structures. The fact that the markets hate uncertainty is certainly on display here.
A Dovish Fed
In its December 17th FOMC statement, the Fed took a dovish stance, with Yellen declaring in the subsequent press conference that the Fed was unlikely to raise short-term rates for at least the next 2 meetings. That makes May, 2015, the earliest the Fed will raise the Fed Funds rate. In addition, the “dot plot,” a summary of where FOMC members believe the Fed Funds rate will be at future dates, showed lower interest rate projections than they had in the last FOMC meeting (October). So, the Fed, at least, did not stir the uncertainty pot.
Historical Perspective – The Asian ‘97/’98 Meltdown
If we go back in history, we find that the Asian meltdown in ‘97/’98 is similar in many respects to what is occurring in parts of the world today. Back then, the ultimate result of the crisis was a Russian default. And so, today, the markets are quite concerned about a similar result. The Russian ruble has been quite volatile in the current scenario, falling as much as 50% in value vs. the dollar at one point on December 16th vs. where it traded prior to the crisis.
Back in ‘97/’98, the emerging market economies went into recession. At the time, Europe did not, but the European governments could not stimulate their economies via fiscal policy due to the constraints imposed by the Maastricht treaty which required certain fiscal ratios for acceptance into the European Union and the formation of the euro currency. How ironic is it that those same European governments are now under similar fiscal constraints, this time in order to save the euro?
Let’s look at conditions in the U.S. at the time and what transpired in the U.S. economy during the Asian meltdown. During the period of the crisis, U.S. real GDP grew by more than 4% each quarter. Of course, we were in the midst of the dot.com bubble. The unemployment rate fell from 5.4% (December ’96) to as low as 4.3% (April, ’98). The price of WTI crude peaked at $26.55/bbl on January 8, 1997 and fell to a low of $10.82/bbl on December 10, 1998, a 59% decline. During the two year period, the dollar strengthened, at one point, by 17.1%. The ten year T-Note yield fell 176 basis points from 6.41% at the end of ’96 to 4.65% at the end of ’98. At the end of ’96, the Fed Funds rate was 5.25%. The economy was growing rapidly, and the Fed had a tightening bias. But, by the end of ’98, the effective Fed Funds rate had fallen to 4.63%.
Now, let’s look at the similarities in the U.S. today to the situation at the time. Many pundits expect real GDP to grow by 3% in 2015 (we believe growth will be closer to 4%). In its December 17th statement, the FOMC believes that by the end of 2015, the unemployment rate will have fallen from today’s 5.8% rate to 5.2%. And, the price of WTI crude had an interim peak of $107.52/bbl on June 16, 2014. Six months later, December 17th, the price closed at $55.93/bbl, a decline of 48%. From June 16th to December 17th, the dollar has strengthened by 10.7%. Today, there is clearly downward pressure on the 10 year Treasury rate, mainly from foreign central bank demand, and demand from U.S. banks due to changing liquidity requirements. On that same June 16th when WTI was at its interim peak, the 10 Year Note closed at 2.61%. On December 17th, it closed at 2.14%. And, while we don’t know where the Fed Funds rate will go, the dovish tone adopted by the Fed at its December FOMC meeting along with the changeover of FOMC members resulting in a net increase in doves, makes it a pretty good bet that the Fed Funds rate will rise more slowly than currently priced in.
How Did Equities Fare?
Finally, let’s look at how the equity markets performed during the Asian meltdown. During the two year period, December, ’96 to December ’98, the S&P 500 index grew 63%. Let’s not forget that this was the dot.com era. Even then Fed chief Alan Greenspan was flummoxed, as he made his infamous “irrational exuberance” comment on December 5, 1996, and the party in equities continued for several more years. Perhaps today, QE is the new dot.com.
The point of this missive is that we have been through a similar chapter in world financial history 16-17 years ago. The conditions look eerily similar. That doesn’t mean all of the results will be similar, but this is the best historical model we have. As I said above, the markets abhor uncertainty. If history is any indication, this may well prove to be a “buy the dips” moment.