While the world’s elite gathered in Davos drinking champagne and giving each other backslaps on saving the world from depression, the world equity markets roared back into the headlines on Friday (January 24th, 2014) by dropping suddenly with triple digit losses.
Is there any cause for concern? What is going on? Well, Model Price Theory (MPT) to the rescue.
Do you believe in leaps of faith?
Well this is where the US economy is right now. And the world financial markets are preparing themselves.
What do I mean by leap of faith?
2013 will go down in the history books as a transition year for the US federal government. From shutting down the government to budget sequestration the budget deficit forecast for this fiscal year (October 2014) will be 3% of GDP. Roughly in line with projected US growth of say ±3%. Down from a high of almost 13% in 2010. This is a big accomplishment and the equity markets have rewarded this behavior with substantial gains.
The $64 million dollar question is whether the other economic actors in the US economy namely non-financial companies, financials, consumers and state/local governments get a sudden surge in confidence about the fiscal prospects to start spending/investing driving the US economy forward.
This is the leap of faith and it’s a biggie!
This is where the US equity markets are at present. Fiscally, after tremendous amounts of stimulus to keep the US economy from entering depression, the US government is back on track of budget deficits in the $300 to $500 billion range for the foreseeable future. In other words, the federal government has done all it can and wants to do to assist the private economy. Monetarily, the Federal Reserve will start to ‘taper’ its bond purchases this month withdrawing its support of asset prices called ‘Quantitative Easing’ or QE.
Something like starting a car on a cold winter morning! Will the engine ‘kick’ over or not? After years of massive government support will the economy start to function normally again, pre 2008 financial crises?
This is how I interrupt recent global equity market and currency declines. Investment dollars are leaving emerging market hot spots (including Canada) and migrating back to the US.
In terms of timing and future economic growth, it’s an interesting place to be, for investors. Global equity markets are pricing in this lull between a government supported economy and a normal functioning economy without government support. How do the global markets price this uncertainty? Simple, they all go down – as we are currently seeing – and as fundamentals improve investors will drive stronger economies both equity and currency markets to new highs. Leaving weaker global markets lower and investors with negative rates of return.
For those wanting more Model Price Theory (MPT) here is what I see.
Here is our ‘Solvency Curve’ that I introduced back in a blog on July 17th, 2012.
Solvency Curve – See Key Concepts for Description
The US federal government – left hand side of the curve – has now stabilized its solvency at 0.135 or on the cusp of the 3RD Order of Insolvency. As scary as this sounds – it’s OK.
The other economic actors – on the right hand of the curve – should start to move upward – becoming more balance sheet efficient – as consumers re-lever (start taking on debt after five years of deleveraging); nonfinancial companies with a record amount of cash – close to $2 trillion – start to make capital investments and grow top line sales and US global banks busting with excess reserves start to invest in a growing economy for higher rates of return on capital.
This virtual circle of economic activity should continue as investment spending and job creation will support future economic growth driving equity values higher.
What is my opinion? Count me as a believer. The US endured one of the largest financial and economic declines since the Great Depression. Federal government policy actions both fiscally and monetarily were effective and innovative. Sure Washington looked dysfunctional at times but the hard and necessary work got done. The global equity markets are now realizing this reality and shifting investment dollars as a result. The US will recover as world’s economic leader where they have been noticeably absent over the last 5 years.
And that’s a good thing!
P.S. For a more detailed account of possible ‘Transitions’ for 2014 see our Acker Finley 4th Quarter (Year End) newsletter called “Transitions” here.
P.P.S. For a more in-depth review and ongoing discussion on our ‘Solvency Curve’ and the US economy over the last two years here are the applicable links.
What is going on with the world of finance, and how do you fix it!
What is going on with the world of finance, and how do you fix it! (Update 1)
What is going on with the world of finance, and how do you fix it! (Update 2)