I was recently a guest panellist at Mount Royal University’s employment forum and faced a barrage of interesting questions. Particularly, one student asked our thoughts on whether the government is doing enough to support the markets, especially taking into consideration the collapse in oil prices.
This question isn’t surprising given the average 20 to 30 years old has never experienced the pain sensation of the sizable market correction, either financially or perhaps in the job market. Today’s teenagers also have only known ultra-low rates of interest, with stories from the double-digit rates of the 1980s sounding nearly the same as stories our parents or grandparents told of walking miles upon miles through the snow just to get to school.
Markets have also become accustomed to such stability, because of continual intervention by governments set on protecting asset valuations at any cost. It’s now reached the stage where central banks have invoked negative rates of interest and some, like the Bank of Japan, have resorted to really buying stocks directly through ETFs to support their equity markets.
The problem is the larger the dimensions and amount of such interventions the higher the chance that things can go terribly wrong when the programs come to an end. Simply take a look at the summer of 2014 when pundits started positioning ahead of a U.S. Fed rate hike.
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Here’s a glance at a few of the chaos around the world with a higher U.S. dollar and plunging oil prices.
Capital outflows in emerging markets
Higher U.S. interest rates or fear thereof has caused a reversal of capital flows out of China and other emerging markets, that makes it very hard to allow them to fund fiscal or current account deficits.
In total, emerging markets saw approximately US$735 billion of net capital outflows with all of but US$59 billion of this coming out of China, based on figures in the Washington based Institute of International Finance which were cited within the Economist. This really is quite the reversal from the U.S.$4.6 trillion of gross capital that flowed into emerging markets between 2009 and 2013, according to IMF data.
Higher U.S. dollar denominated debt
Another issue is all the dollar-denominated debt, which has exploded higher in emerging markets, more than doubling from US$2 trillion to US$4.5 trillion in the last 5 years, according to the Bank for International Settlements (BIS). Consequently, emerging market debt payments have raised by 20 to Half in the past couple of years thanks, in part to the increase in the dollar against local currencies.
As an effect, investors have hit the panic button and also have sold Chinese stocks, pushing them down to a 13-month low, using the overall emerging market correction in the last few weeks now eclipsing the 1997 Asian Crisis correction and also the 2008 Financial Crisis.
Collapsing oil prices wreaking havoc
The rocketing U.S. dollar has also contributed to the dramatic effect on commodity prices, especially oil, that is rapidly destabilizing the oil-producing regions on the planet.
In the center East, the countries of the Gulf Cooperation Council are running large deficits estimated at US$125 billion in 2015 and expected to total over half-a-trillion dollars over the next 4 years, according to the IMF.
Even mighty Saudi Arabia, which relies on oil to fund 75% of its budget, is feeling the pain. The IMF now estimates that the country will run out of profit under 5 years if oil stays below US$50 a barrel.
The real pain is being felt by countries such as Brazil, that is facing its deepest recession since 1990 and it has been unsuccessful in attempts to stop its currency from collapsing, producing a 10-per-cent inflation rate.
Investors have recently caught on that collapsing oil prices along with a high U.S. dollar are destabilizing not just emerging markets but those closer to home as well.
Analysts understand that the oil crisis has a dreadful affect on U.S. earnings growth and therefore are ratcheting down their earnings estimates, factoring within the weakest biggest back-to-back expansion since the economic crisis.
As an effect, the S&P 500 has become beginning to track oil prices with an increasing correlation forwards and backwards, a trend that people expect to continue within the coming months. Look for a recovery in oil prices along with a drop in the U.S. dollar to have a positive affect on U.S. equities, something the Fed will be keenly aware of within their upcoming meetings.
Martin Pelletier, CFA, is a portfolio manager at Calgary-based TriVest Wealth Counsel Ltd. twitter.com/trivestwealth