Thanks to the Bank of Japan – where interest rates are now negative out to eight years – the financial markets now seem to assume that central banks will keep pumping out endless money to help shore up their lackluster economic growth. Specifically, on Friday, the Bank of Japan announced that it would cut its key deposit rate to -0.1% from +0.1% and then said that “we will cut the interest further into negative territory if judged as necessary.” Clearly, deflationary forces are now spreading around the globe.
The European Central Bank (ECB) will meet this week and they may also choose to push their already-low (-0.3%) key interest rate further down to -0.4%, since ECB President Mario Draghi has implied that more accommodation may be necessary to help shore up Italian banks that now have more than 10% non-performing loans and too much emerging market exposure. Meanwhile, in the U.S., fed funds futures are now forecasting virtually no interest rate hike in 2016. So with interest rates collapsing around the globe, stock markets are suddenly more attractive, especially high-dividend stocks with a history of rising yields.
Interestingly, both former Fed Chairman Ben Bernanke and Vice Chairman Alan Blinder have said that the Fed should add negative interest rates to its toolkit. In an interview with Marketwatch last Friday, Bernanke said, “I think negative rates are something the Fed will and probably should consider if the situation arises.” If so, the U.S. would join the Bank of Japan, the European Central Bank, and the central banks of Switzerland, Denmark, and Sweden with negative rates. Clearly, we live in a strange new world!
Last Friday, the Commerce Department announced that their preliminary estimate for fourth-quarter GDP was an annual pace of 0.7%, which is a sharp deceleration from an annual pace of 2% in the third quarter and 3.9% in the second quarter. For all of 2015, U.S. GDP grew at a 2.4% annual pace, the same as 2014. Overall, consumers are now driving virtually all of U.S. GDP growth, but consumer spending decelerated to a 2.2% annual growth rate in the fourth quarter, down from a 3% rate in the third quarter.
Additionally, exports declined 2.5% in the fourth quarter, while imports rose 1.1%, so a wider trade deficit is also causing a bigger drag on GDP growth. Business investment also remains poor and declined 5.3% in the fourth quarter. Shrinking inventories also put downward pressure on fourth-quarter GDP.
Before this downbeat GDP data came out, the Federal Open Market Committee (FOMC) met on Tuesday and Wednesday. The official FOMC statement released on Wednesday said that the Fed is “closely monitoring global economic and financial developments and is assessing their implications for the labor market and inflation, and for the balance of risks to the outlook.”
Although the FOMC acknowledged that “economic growth slowed late last year,” they also said that the U.S. economy is still growing at a “moderate pace.” There was a significant change of language when they said that business investment is now “moderate” vs. the “strong” in the previous (December 16) statement. In other words, the Fed did its best to imply that it may not be raising key interest rates anytime soon. In fact, the fed funds futures market no longer anticipates that the Fed will raise key interest rates at its mid-March FOMC meeting.
Even though the Fed and many businesses have expressed concern, consumers are not that concerned. The Conference Board announced last Tuesday that consumer confidence rose to 98.1 in January, up from 96.3 in December. Consumer sentiment is tied more to housing prices than the stock market, so it’s fitting that on Wednesday, the Commerce Department announced that new home sales rose 10.8% to an annual pace of 544,000 in December, up from a revised 491,000 in November. For all of 2015, new home sales rose 14.5% to 501,000. During the past 12 months, new home prices rose 4% to $294,575 compared with 2014. Continued home price appreciation remains crucial to boosting overall consumer confidence.
On Thursday, the Commerce Department announced that December durable goods orders declined 5.1%, the biggest monthly decline in 18 months. Defense orders plunged 46% and commercial aircraft orders declined 29%. Excluding transportation orders, durable goods orders still declined 1.2% in December due to weakness in key industries. Business investment in 2015 was the weakest since 2009 and continues to put downward pressure on durable goods. For example, shipments of core goods declined 0.2%.
Commodity Price Deflation is Punishing Russia
Even though our leading indicators are mixed, the U.S. is doing well compared to Russia, whose Federal Statistics Office announced last week that its GDP contracted 3.7% in 2015. Retail sales declined 10% and business investment fell 8.4%. This is the second year in a row that Russia’s GDP has contracted. In the past two years, the Russian ruble has fallen a shocking 58%, from 32.5 per U.S. dollar at the start of 2014 to 77 per dollar now, according to Trading Economics.
Obviously, such a dramatic plunge can destroy consumer purchasing power. Since many countries in the Middle East, North Africa, as well as Russia and Venezuela are overly dependent on crude oil prices, it is very possible that unrest in these countries will persist and some borders may be redrawn, especially in the current Middle East conflicts.
The real risk in the global stock market is that commodity deflation has devastated commodity-related stocks and commodity-dependent nations. The energy sector malaise has now spread to many financial stocks, due to their growing default risk. I am not yet ready to say that deflation is spreading to tech stocks, since Apple’s (NASDAQ:AAPL) operating margins continue to expand and it still has pricing power; but the real risk to the stock market is persistent selling pressure as deflation envelops the globe. For example, there is already a lot of selling pressure emanating from sovereign wealth funds, especially in the Middle East (see: Financial Times, February 1, “Sovereign wealth funds drive turbulent trading.”)
Overall, there are a lot of wildcards that may impact financial markets in 2016. The Bank of Japan’s abrupt switch to a negative interest rate policy was definitely one big surprise. Now it will be the ECB’s turn to possibly surprise us further. One thing is certain: Countries are continuing to systematically devalue their currencies, so the U.S. dollar is destined to remain strong due to higher real interest rates and better growth than many other countries. This means that a stronger dollar will continue to put more downward pressure on commodity prices, so I expect these deflationary forces to continue to spread.
The Presidential election outcome also remains uncertain, but after the Florida “winner take all” primary on March 15, there should be just two or three leading Republican candidates left, so political uncertainty should diminish in the upcoming months. In the meantime, Libya remains a wildcard, as does its crude oil production, since ISIS is now effectively taking over the country. Three ISIS leaders were recently killed via long range snipers, so either special forces from selected countries are in Libya or possibly this is the start of a much more serious conflict that is about to escalate. Ironically, this also means that crude oil prices could surge if there is any kind of prolonged conflict. So, a lot of wild cards are in play in 2016.
Disclosure: *Navellier may hold securities in one or more investment strategies offered to its clients.
Disclaimer: Please click here for important disclosures located in the "About" section of the Navellier & Associates profile that accompany this article.