Our house view is that non-economic factors played the largest role in the recent market turbulence. We discuss these below and forecast their future development.
1) Firstly and most importantly, Ebola: clearly the scare has impacted markets, but it is strikingly positive that the disease does not seem to spread very easily outside of Africa. Predictions are difficult, but the signs are clearly pointing to a major reduction in this crisis, so markets have already recovered about half of their recent losses. Also, the vitriolic attacks by many Republicans on President Obama and his administration’s role in fighting Ebola (often magnified by a sensationalist media and right-wing websites) are clearly being driven by another non-economic factor: the upcoming congressional elections. However, their advocacy of closing the national borders will likely backfire if the disease wanes in the US.
2) Russian sanctions and threat of a cold European winter: It is quite clear that the Russian sanctions are a significant factor pushing an already feeble European economy into semi-recession, but this non-economic-sourced factor is now actually having a negative global effect. Perhaps US and European policymakers are willing to further hobble the global economy for the sake of uniting a deeply divided Ukraine, but political egos are hard to reverse. Meanwhile, there must be considerable fear about a cold winter in Europe due to reductions in Russian gas supplies, and fighting in the Ukraine remains severe, so there is little hope for major improvement.
3) Politically-driven Saudi oil policies are driving global markets. It seems that the Saudis increased production in September, indicating that they wish to push the price down to reduce the profitability of US shale energy (thus curtailing its production) and punish Putin, who backs Syria and Iran and who is a major competitor in oil markets. The US may support this effort for obvious non-economic reasons. Normally, lower oil prices assist the G-3 economies, but currently: 1) it causes fears of deflation in risk markets, which impact consumption via the wealth effect and 2) a major portion of US economic growth during this recovery, especially capital expenditures, has been tied to the shale bonanza. The damage to the Saudis’ own economy is severe, however, so we expect them to cut production soon.
4) The Obama Administration’s action to hinder “inversions” (in which US companies acquire foreign companies in order to reduce overseas taxes) removed a great amount of valuation “froth” from M&A targets globally. This policy is very unlikely to be changed or evaded, as well.
5) Due to global pressure, the Irish government decided to halt its largest tax scheme, nicknamed the “Double Irish” system, for new applications and will phase out existing users over the next few years. This likely will reducemultinationals’ net profits after 2020, thus reducing equity valuations to some degree.
6) A surge in Greek bond yields was caused from the Prime Minister’s rebuff of the IMF for political advantage leading up to the Presidential election, thus renewing some fears of a Eurozone breakup. These bonds are actually more properly priced now, in our view, and it would not be surprising if other peripheral bond yield spreads started to rise from current extremely low levels, but this should not cause a Eurozone crisis.
There have been economic reasons, as well:
1) China’s economic slowdown (which is likely much worse than in the official statistics) is impacting Europe.
2) US retail sales for September were poor. However, in real terms, they remained firm, in our view.
3) 4Q guidance by a few US companies was quite negative, but not disastrous for the overall market. The recently stronger USD will likely negatively impact US multinationals’ profits, but from a global perspective, the reverse is true for non US companies.
4) European macro-economic data remained weak. Given the continuing, and potentially heightened, Russian sanctions, Europe should continue to sputter, but we do not see a deflationary hard-landing or a “2011 crisis.” Like Japan’s recent experience, overall corporate profits may even rise during this weak macro-period, due to currency and other factors.
5) US bank lending continues to decelerate. The 3-month annualized rate is down to 5.4%, nearly a 2014 low. Perhaps this is not a disastrous development, but if it decelerates much more, it would be concerning, especially for non M&A related lending.
It is difficult to characterize the following factor as economic or non-economic, but most momentum and non-fundamental investors, who are often highly leveraged, were recently “forced” to sell risk assets. This “shakeout” should lead to more fundamentally driven markets going forward and reduce officials’ fears of over-speculation.
In our late September meeting for the house view, we underestimated the panic over Ebola, the effect of Russian sanctions on Eurozone economic growth, and other non-economic factors, as well, but given the above views, we expect risk markets to overcome the net effects, although we are hardly expecting a very bullish market. Our target for the SPX to rise slightly above its recent high is only 7% away and continues to look quite achievable once some of the panic surrounding these issues calms.