The first meaningful swoon in the stock market in quite some time culminated in October. On October 15, the VIX, which measures implied volatility for large cap stocks, reached 31, up 201% from its 2014 low of 10 on July 3rd. The markets seemed to be expressing concern over a global economic slowdown, with particularly weak news coming out of Asia and Europe. On October 16, James Bullard, the President of the St. Louis Fed, suggested that the Fed could pause the tapering of bond purchases associated with end of QE. On October 31, the Bank of Japan (BOJ) made a surprise announcement that it would buy up to 80 trillion yen of government bonds, equities, and real estate funds. Stock markets around the world responded favorably.
It has been clear that monetary policy in the form of QE has boosted equity prices. Nonetheless, on the margin, economic growth has been slowing around the world, including in the United States. The BOJ announcement came on the heels of news that household spending was down 6% year over year, housing starts were down 14% year over year, and construction spending was down 40% year over year. More recently, both Sweden and China reduced interest rates in the face of economic weakness. Equity markets liked that, too. Bad economic news plus monetary stimulus equals rising stock market. What gives?
In addition to the Great Depression of the thirties, central bankers have been studying Japan, which for the last two decades has lived with deflation. Deflation is dangerous because it encourages consumers and businesses to delay buying in anticipation of lower prices. Excess capacity and inventories mount, forcing prices down further, confirming suspicions, and promoting further delays in purchasing. In deflation, the real value of debts rise and the incomes to service them fall in nominal terms. Even if nominal rates are zero, real rates are always positive. Bankruptcies mount and new borrowing is discouraged.
The European Central Bank, the Bank of England, the BOJ, and the Fed all have the same 2% inflation target, not because they love any degree of inflation, but rather to serve as a cushion against deflation. Modest inflation helps borrowers repay their loans. Remember that the 2008 financial crisis was set off by excessive subprime loans. Until debt levels are normalized, we will experience slow economic growth. Aggressive monetary policies have reduced interest rates, reducing the incentive to institute structural reforms, which would enhance labor productivity and improve capital allocation. The emphasis today seems to be to try to revive past successes of export driven economies by reducing the value of currencies as a means to gain competitive advantage. Promoting exports is often politically easier than facing labor unions and powerful business lobbies.
But exports are weakening in many countries. Germany, with the world’s largest trade surplus, saw export growth drop to 0.9% last year from the 8% average before the financial crisis. Chinese export growth has dropped from its 20% to 30% norm to 8.6% last year. The World Trade Organization has reduced its forecast for international trade growth in 2015 from 5.3% to 4% and said the risks are “predominately on the downside.”
Without an easy solution, deflation continues to be a concern. Although the Fed has stopped its QE asset purchase program, it remains to be seen when they will actually increase short term interest rates, and it may even reinstitute QE if growth does not materialize. Central banks continue to have a bias toward monetary stimulus, without which investors will have to pay greater attention to the economy and focus on subpar growth in the U.S., slowing growth in China and looming recessions in Japan and Europe.
John Hess 
Falgun Jariwala 
Managing Principal Managing Director
jhess@nsinvestors.com fjariwala@nsinvestors.com
www.nsinvestors.com www.nsinvestors.com
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