Written by Nate White, Chief Investment Officer of Paragon Wealth Management
It looks like we are finally starting to see the consequences of the Fed’s great monetary easing experiment. Getting in was easy – getting out maybe not so much. The fear throughout the Fed’s great adventure was what type of unforeseen consequences could the happen as a result of QE and artificially low interest rates. Now we are starting to find out.
Along with others, I have said for some time now that QE has distorted the markets. It has recapitalized the banks, which I believe was the main purpose, but the exceptionally low rates and asset purchases have supported asset prices and distorted credit markets as well. The need for yield has caused massive amounts of money to flow into the corporate bond space. Almost all corporations have been able to borrow with ease. Many projects that otherwise would not have been taken on had rates been more normal have received the green light. Due to lack of robust economic growth much of the borrowed corporate credit has gone into share repurchases rather than being used to expand business. It’s hard to blame the companies though for borrowing as much as they can at these low rates.
The process of normalizing monetary policy (i.e. ending QE and raising interest rates) has caused the dollar to strengthen because our rates are higher relative to other developed nations. The other developed nations such as Europe and Japan are just beginning their QE programs which causes their currencies to weaken relative to the U.S. Since commodities like oil are priced in dollars a rising dollar pushes the effective oil price down. A stronger dollar can also encourage capital flight from developing nations and decreases the attractiveness of US products and services.
The dangers of a credit bubble in high yield space and perhaps other corporate areas could be coming to light. (https://www.bloomberg.com/news/2014-12-11/fed-bubble-bursts-in-550-billion-of-energy-debt-credit-markets.html) The low level of interest rates has created a huge demand for anything with yield. Junk rated companies have been able to borrow with ease. Higher rates would have discouraged this. Example: Much of the energy boom in the US has been financed with this cheap credit. This caused production and supply to surge causing an oversupply situation with oil. Exacerbating the situation has been the aforementioned rise in the dollar.
When the prices of anything goes down it is good for those who use or buy it – until a certain point. As oil drops it lowers consumers fuel costs and is good for all industries that use it as an input. However, at some point the positives from the drop in price become a negative. If the drop in energy prices gets so low that it causes the energy companies to fail on a massive scale it then affects the economy as a whole. At some point the crash of an industry can become systemic and affect the economy as a whole – think the dot-com/tech and real estate bubbles. Whether this happen spill-over effect happens in relation to what is going on in the energy space remains to be seen.
The same effect can be seen on a geo-political and global economic level. The dramatic drop in oil is now getting so low and causing tremendous pain for countries like Venezuela, Iran and Russia. At first we don’t shed a tear because these aren’t our Favs, but what if Putin and the Iranian clerics do something drastic if they feel they are backed into a no win situation? Venezuela is getting close to default and that is having ripple effects on other emerging markets.
I don’t mean to be so tough on the Fed as I don’t believe they are the cause of all our present or future troubles. Nothing happens in isolation and they are one piece of the puzzle as there are many other factors at play (e.g. regulation, fiscal policy, etc.). Let’s hope the adjustment back to a more normal monetary policy can be made without too much pain and disruption.
Could what is currently happening with the energy markets be a sign of things to come? How far does the unraveling go? Does it become systemic or not? How much is already priced in? No way to know until after the fact. One thing for certain is that these type of events will create opportunities in the markets that we have been waiting for.