Macro Commentary

It’s all about expectations.  The value of a financial security, whether a stock or a bond, is an investor’s assessment of what all of the future cash flows to be received are worth in today’s dollars.  Since the future is unknowable, we could say it is the market’s expectations of what future cash flows will be.  In that sense, finding outsized returns in the investment markets is about finding disconnects between the market’s expectations and your own as an investor – and being right.  During the week, we continued to see the near-term market repercussions play out of two big sets of expectations driving the market today.  First example is the country that has once again taken over the majority of news headlines, and these weekly write ups recently – Greece.  People are nervous.  Big picture, expectations are that a Greek default either will not happen or will be a relative non-issue.  If investors believed that a default would occur (if a technical one has not already) and would trigger an economic impact (say another recession in Eurozone) then we would be seeing a much bigger drawdown in equity markets (Europe in particular) that we have seen.  Credit spreads in other peripheral countries have not widened significantly.  Still, recent market weakness says that people are on edge.  We have said in past write ups that this particular issue has lasted longer than anyone expected.  Surveys have shown that the Greek people themselves really do not want to exit the Eurozone.  Meanwhile, European officials have called an “emergency” meeting in Brussels on Monday as we get closer to month-end.  Perhaps the metaphor of a “game of chicken” is most apt and it will not be until the final seconds that someone flinches.  In our mind, the market base case that a deal is had to perpetuate the status quo (which is really no resolution at all) remains the most logical.  There is a little concern over the big question mark that hangs over the “what if” of a Greek exit.  We also recognize that a question mark is not necessarily all bad in the long run.  If advance preparation by the banks maintains financial stability, the economic impact on the Eurozone by a falling Greek economy should be mute and the power of reinforcing that actions have consequences may improve economic integration of the remaining members.

The second expectation reinforced this week was the likelihood and timing of action by the US Federal Reserve.  As expected, there was no action this week.  Yellen’s commentary indicated that the Fed remains on track for a rate increase at some point in 2015.  This is logical since raising short-term rates rebuilds the “armory” a bit for the next battle against a cyclical economic downturn.  Clearly the concern of the market, and expressed by both the IMF and the WorldBank, is that the US acts too quickly and hurts its growth or, more likely in the IMF and WorldBank view, vacuums up capital that would be needed in the rest of the world. At some point, zero interest rates must become something positive and it is natural to worry that it is too soon.  The US is clearly closest to needing to “normalize”, but we have all seen how policy decisions can cause as much damage as it can good (e.g. the “double dip” recession of the Eurozone in 2011).  Expectations priced into financial securities are that the Fed raises rates a little (say 25bps, futures are priced for a roughly 37.5bps increase which shows that they are split between 25 and 50bps) but then pauses.  Frankly, that also seems logical – test the waters for effect.  Economically speaking, we should not see much of an effect if the Fed follows through on those expectations.  The folks at the Fed are smart and see the same concerns and issues that the rest of the world does, so we think that if the base case is wrong it is more likely that they err on the side of spreading further increases out over a longer time.  Financial markets speaking, we would not be surprised if there is a bit of fear (read sell off) when it happens depending on what the commentary from Yellen is (i.e. does she reinforce the pause before further action?) but there is no information edge on when to “trade” the portfolio.  The market could just as easily rally on the news since it finally happened after so much telegraphing (such as what happened in the 30 days after the US ended its QE program).    

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