The first volume in my series is set in Europe. The market has long known that many nations, not just in the periphery, have failed to deliver on the structural reforms that would finally produce self-sustaining growth and increase employment. European economic releases, while generally not horrible, have been dreary; the continuing slide downward of inflation toward deflation typifies the gloom. Sanctions against the Russians have weakened growth prospects, and the fighting over allowed deficits engaging France and Germany has not increased confidence in leadership. Bund ten year yields falling below 1% has indicated the victory of the return-of-my-money crowd over the return-on-my-money mob. It’s too early to see benefits from the Euro’s decline. Simply said, the market has no confidence that the European economy has bottomed.
Volume two is set in China. In that distant land, wily ‘magicians’ have used borrowed money to inflate cities in what had been farmland. Appetite for buying homes has been wavering in China, even though the ‘magicians’ have resumed casting spells to make the home buying fervor reappear. The flock of I-told-you-so economists and short-sellers has thickened, screaming as loud as they can that economic expansions based on borrowed money will end badly, even if that economy has trillions in reserve. With the genuine decline in local demand, weak demand from elsewhere, and the noise from the nay-sayers, the market has no confidence that the Chinese economy has bottomed.
Volume three is a bit of a continuation of volume two. Volume three is set in remote villages around the world that produce the stuff that built the cities in volume two. One recent morning, the villagers woke up to discover that the iron ore, copper, coal and crude oil that they had been assiduously pulling out of the ground was no longer needed the way it had been by the ‘magicians’ who built the cities. Instead, the massive expansion in capacity that had been built to serve the ‘magicians’ wasn’t really needed at all. On that realization, prices in the commodity complex tumbled, and the companies and investment strategies that had been built around it were suddenly stranded in those distant villages. The villagers stopped pulling iron ore and coal out of Brazil and Australia, and the shale which had been harassed by fracking in the US got some rest. Some villagers in Saudi Arabia, who reliably would cut oil production to keep prices high, decided they no longer would enable others’ bad behavior and so they kept pumping as much as they could.
Volume four is set in the US, where the wizards at the Federal Reserve had conjured up wave after wave of monetary stimulus, even while the US deficit was falling. The result of their conjuring was an economy that actually grew and created jobs, but had the freakish side-effect of bond yields falling even while growth accelerated. Pundits scratched their heads about this strange behavior of the bond market, and wondered if the bond market knew something about the future. Was US growth about to fall off due to the weakness in Europe? Would the expected and desired rebound in inflation to 2% occur, or would it slide like in Europe? Quickly, things that were good such as low mortgage rates, cheap gasoline, and inexpensive natural gas to heat one’s home all became auguries of bad things to come. Problems also emerged from some alleged magic conjured years ago by ex-wizards Dodd and Frank, which poured truckloads of molasses into the bond market machine, making it impossible to sell bonds anywhere near where they were marked.
Future volumes are in production. We expect that coming volumes will not be as exciting as volumes one through four, as many of the nasty plot twists that we devised will move from being new and scary to continuing and miserable. Confidence that Europe has bottomed may come as exports pick up due to the cheaper Euro, but realistically won’t appear until the spring of 2015. We are trying to write how the wizards at the ECB save the day with spell after spell of QE, but yields are already so low there the magic has a hard time catching on; further, the ECB wizards are tired of needing to do all the work themselves while the politicians posture.
We see varying fates for the commodity villagers. Although we see an overall decline in spending to build more capacity, we see some villages snapping back much faster than others. In particular, US oil production growth will slow or reverse until prices recover, partially alleviating the oversupply condition, which may have been exasperated by the end of vacation driving season and refinery maintenance downtime anyway.
We know we will be writing about other good things happening in the US. The decline in commodity prices will keep more money in people’s wallets, and they will spend this money going out to eat or buying new clothes. Not only will more people find jobs, but people with jobs will see their incomes increase! This increase in wages will become evident to the wizards at the Fed, who will end QE this month and start increasing short rates in the middle of next year. Although we see longer-dated Treasury bond prices falling as recent scary events recede into bad memories, we see good performance from economically sensitive risky assets such as stocks and high yield bonds. US Treasuries will remain in high demand from outside of the US, tempering the price damage. However, we think ex-wizards Dodd and Frank seriously damaged the bond market machine, so we expect credit spreads not to rally through the tights seen earlier this year as investors will demand a higher illiquidity premium.
We don’t think we can yet re-title our work as “A Series of Fortunate Events” anytime soon. We see recent market moving events as being related loosely through their causes, but their combined effect caused a magnified sense of impending doom. However, like the Baudelaires, we expect risky assets to escape the villain’s traps with only some scratches and good stories.