“Yes It’s Been Quite a Summer, Rent-a-cars and West Bound Trains”[i]

Ideally summertime offers chances for getting away to relax.  This typically involves leaving the day-to-day stresses behind and enjoying some nice weather perhaps in the mountains or at the beach.  2015’s summer, however, hasn’t allowed much downtime as the headlines have been both significant and active.
This shouldn’t be a surprise as any year that includes Hillary Clinton and Donald Trump in a presidential campaign will be memorable.  The developments and sound bites from Camp Clinton and Trump should make the next few months interesting.  But there are some other astonishing events playing out – the ongoing saga over whether Greece remains in the European Union or finally departs.  And then what it means to the European financial system.
Additionally, there is the battle over the Iranian Nuclear Deal, Puerto Rico telling creditors it may or may not pay them mañana, and the Fed both deciding when to raise interest rates and then deciding how to let the markets know.  And finally, China choosing to devaluate their currency, the renminbi, against the U.S. dollar, relations with Cuba and, of course, Bruce Jenner.
Certainly there are many other important developments and ranking the list in order of importance is a challenge. We think that near the top of everyone’s lists should be monetary policy and the Federal Reserve.  Specifically, when the Fed will raise interest rates and what it means for the economy and capital markets.
[i] Jimmy Buffett, 1974
“I’m Tore Down, I’m Almost Level With the Ground”[i]
As we know, interest rates are low.  But, within a historical context, it is astonishing how low they are.  In many cases, they have NEVER been at these levels – and “NEVER” involves 500 years in some instances!!  The Dutch government bond markets dates back to 1517.  The lowest yield levels were hit earlier this year when the yield on their 10-year bond touched 0.45%.  The Bank of England was formed in 1694 and the “base lending rate” was established in 1705.  The current rate of 0.5% is the lowest ever.  Landmark lows in other sovereign markets include France (dating back 1746), Italy (1807), Germany (1807), Spain (1821) and Japan (1870).  As Michael Hartnett, chief investment strategist at Bank of America/Merrill Lynch, points out “There have been depressions, wars, earthquakes, famines, all sorts of stuff, yet interest rates have never been lower”[ii]
Shifting from history to looking forward, it seems that the only thing the financial media talking heads are concerned with is when the Federal Reserve will increase interest rates.  The hyperbole surrounding this decision would make reasonable men and women conclude that the future of the human race depends on what the Fed does.  Sadly, perhaps this is not hysteria but reality.
To be sure, our monetary policymakers have followed their current strategy with the well intentioned goals of preventing another crisis as well as restore the economy to growth.  However, their strategies of zero interest rates, asset purchases, and other stimulative efforts aren’t guaranteed to accomplish their objectives.  In fact repressing interest rates distorts the value of any financial asset because of the artificial interest rate used to discount future cash flows.  As Jim Grant describes it, “With one hand, the Fed is manipulating interest rates, therefore the value of myriad financial claims tied to interest rates.  With the other hand, it’s trying to impose safety and soundness from on high.  Left hand and right hand are working at cross-purposes”.[iii]
Beyond the capital markets, record low interest rates are an economic obstacle rather than the intended contributor.  Charles Gave from GaveKal Research describes the issues, “As a rule, entrepreneurs have zero confidence in prices fixed by the authorities, which can change overnight on a politician’s whim (as anyone who invested in Spanish solar power learned to their cost). They also know that very low interest rates bring forward future demand, and they worry what will happen when there is no longer any future demand to bring forward. In response, they stop investing in order to maximize the cash on their books or to buy back their own shares. Meanwhile consumers, knowing that businesses want to reduce their wage bills and afraid they will lose their jobs, begin to save as much as they can. The result is a collapse in the velocity of money, and declines both in economic activity and in prices.”[iv]
Despite good intentions, perhaps manipulating interest rates and capital flows is not providing the desired outcome.  Growth has been much lower than previous economic recoveries and wage growth has been elusive.  This deviation from the planned outcome risks a reduced confidence in central banks which could cause further market volatility.
Last week the Dow Jones Industrial Average fell 1,000 (5.82%) including a 500 point plunge on Friday.  It was the largest weekly point drop for the Dow since 2008 and Friday’s loss was the worst in four years.  The Dow is now down 10.3% from its record high set on May 19th and this is the first time the index has experienced a 10% correction since 2011.  There is nothing significant about the 10% threshold (other than it’s a round number) but it does show that stocks have steadily climbed in recent years.
Here are the year-to-date numbers for the major averages.                              2015YTD[v]                                     Dow Jones Industrial Average  -7.7% 
S&P 500                                   -4.3%
Nasdaq Composite                   -0.6%
Russell 2000                            -4.6%                           
Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividends
Some other notable market developments include crude oil declining to $40.00 per barrel (down 33.7% YTD) and the yield on the 10-year Treasury note falling to 2.05%.  Gold rose 4% last week closing the week at $1,160 per ounce.
Emerging markets experienced much of last week’s pain as China reported some soggy economic data increasing worries of slowing growth.  The purchasing managers’ indexes fell to a 6 ½ year low and imports fell 8% in July.  This pressured all emerging markets.
While the slumping stock market grabbed everyone’s attention, real news was happening in the foreign exchange markets.  China, Vietnam, and Kazakhstan devalued their currencies against the dollar.  It would be easy to shrug the shoulders and mutter ‘Vietnam and Kazakhstan don’t matter’.  This was probably a common reaction to Thailand’s baht devaluation which started the 1997-1998 Asian Crisis.
“I’d Like to Get You on a Slow Boat to China”[vi]
Regarding China’s devaluation, there are several theories behind this decision.  China had pegged the value of the renminbi to the U.S. dollar so as the greenback strengthened vs. other currencies over the past year, so did the renminbi.  This placed China at a slight disadvantage from a global competitive perspective.
Many believe the move was an effort to increase the chances of being included in the IMF’s Special Drawing Right.  This SDR is a basket of global currencies but is not used for foreign exchange or trade.  It is largely a symbolic IMF gadget.  However, inclusion, which will be decided in a November decision, is important to the Chinese government.  A pegged renminbi would be harder to get IMF approval as it would be viewed as the same as the U.S. dollar.  So China views breaking this tie to the dollar as a necessary step in the renminbi’s evolution.
Another factor influencing this move is the fact that China wants to expand their capital markets to have a bigger global presence.  Free trading markets are an important component of that equation.  Unhinging this peg to the dollar sends a message to the international community that China is serious about moving to a market based system (at least in some areas).
After last week, the financial markets will struggle with whether these devaluations and slowing emerging market economies will result in recessions in the developed countries.  Or the cheaper energy costs will continue to lower cost structures and drive further global growth.
Some are proclaiming that last week will be like October 2014 when U.S. stocks fell 7% in the first half of the month only to fully recover in the second half of the month.  After that, they resumed the pattern from the past couple of years namely a gradual and steady advance.
The ursine side of the debate points to the damage to the global economies and stock markets.  While last October turned out to be a “V” bottom, there are many other dynamics in 2015 that make a repeat unlikely.  The U.S. will be raising interest rates, many economies have too little growth and too much debt, and the stronger dollar hurts major U.S. companies.
As summer winds down, we realize that it has been an eventful year.  And it has not all been bad – we have a triple crown winner in horse racing (first in 37 years), the U.S. women’s world cup team won the gold medal, Serena Williams winning 2015’s first 3 major tournaments in tennis (the U.S open forthcoming), and the New York Mets are in first place.  We hope that some of this good news flows into the capital markets and calms things down.  A little chance to catch our breath would be helpful.  The remaining four months of 2015 should be very interesting.

[i] Carbert Music, Inc. 1961
[ii] Bank of America/Merrill Lynch, “The Longest Picture”, February 22, 2015
[iii] Grant’s Interest Rate Observer, March 20, 2015
[iv] GaveKal Research “Five Corners”, July 15, 2015
[v] The Wall Street Journal, August 22-23, 2015
[vi] Frank Loesser, 1948