John Dessauer Investments, Inc. www.johndessauerinvestments.com John Dessauer s market review and update as of Wednesday March 22, 2017 The U.S. stock market has been remarkably calm in light of an interest rate hike, wide spread media hysteria, and a high level of economic uncertainty. The question is, can this continue much longer? Before the election, the media and market pundits warned that a Trump win would unleash uncertainty and market turmoil. Immediately after the election those warnings were amplified, but the stock market has refused to comply. Instead, we have enjoyed a historically low level of stock market volatility. And if the current analysis is correct, the stock market is likely to remain calm for quite a while. In answering the question of why the calm has prevailed, Reuters has this to say: The best explanation may be the most mundane: the global economy s growth is at its most steady and predictable for decades, since recovering from the financial crisis, trumping any short-term political surprise, even in the White House. Crucially, the economic recovery and consequent stability hasn t been built on a borrowing binge, suggesting the low volatility climate can continue- with episodic spikes- even should there be more political shocks in store, such as in Dutch, French or German elections this year. Jan Loeys, head of global asset allocation at JP Morgan adds: This is a very stable world economy. It s never been so stable, and this is why the market is so stable and risk premia so low.
According to the World Bank, annual global growth since 2011 has stayed in a narrow range, 2.3%-3%. The International Monetary Fund says the range is even smaller 3.1%-3.5%. For this year both organizations are forecasting growth within their ranges, indicating another year of low volatility on stock markets. The VIX index is a measure of implied volatility in U.S. stock markets. It is tagged as Wall Street s fear index. It s around 12% currently, and has rarely been lower in its 26-year history. There is a similar story in Europe s stock markets. The benchmark index of euro zone market volatility is around 15%, which is one of the lowest points in its history. Research by equity analysts at Citibank shows that stock market volatility around the world is below the 10-year median. It s especially low in France, Britain and the United States, where it is more than 50% below the median. According to most of the mainstream media and Trump critics, the opposite was supposed to be the case. By now the U.S. and global economies should be in turmoil because of Trump s divisive policies on issues such as immigration and world trade. The media pundits and Trump critics have been totally wrong, but that has not diminished the media noise about Trump s potentially negative impact on world markets. Deutsche Bank s George Saravelos and Rohini Grover wrote a note last week saying: If politics weaken growth, volatility will rise. But so long as the current unusual confluence of strong data but uncertain politics continues, volatility is likely to stay subdued. What happens when growth rates rise? JP Morgan s analysts say that volatility in global growth is the biggest single driver of financial market volatility. And since recovering from the 2007-2009 crisis, growth has been steady and predictable almost to the point of boring.
The logical conclusion is that if the Trump administration succeeds in lifting growth to 3%-4%, stock market volatility will remain low as long as growth remains steady and predictable. That could mean a calm steady stock market well into 2018. It is becoming controversial. It is Interest On Excess Reserves (IOER) - money paid by the Federal Reserve to banks, mainly large American banks. Banks are required to keep a portion of depositors money in an account with the Federal Reserve. No interest is paid on these required reserves. More than a decade ago, Congress authorized the Federal Reserve to pay to banks interest on money held in their accounts in excess of the reserve requirements. Last year Federal Reserve interest payments to banks amounted to $12 billion. With interest rates on the rise, that amount will be $27 billion this year and could be $50 billion in 2019. Critics say this is a subsidy for banks, especially the big banks. They have a point, because about half of all bank reserves are held by the 25 largest banks. Critics also say paying interest to big banks gives them an incentive to play safe rather than lend the money to businesses and consumers. There has been some talk since the election about requiring changes in the way the Federal Reserve operates. Interest on bank reserves is one of the Federal Reserve s tools under scrutiny. IOER is the Federal Reserve s main tool for establishing the level of short term interest rates. Meddling with IOER risks losing future battles to control inflation and could prove very costly for all Americans. Ever since the 2007-2009 financial crisis and recession, banks have been more conservative, holding far more in their accounts at the Federal Reserve. They continue to do so. One major reason is the Dodd-Frank legislation which has imposed a wide range of new
regulations on banks. Dodd-Frank is still evolving. There are new regulations that have not yet been detailed. Therefore, banks are playing safe by holding more money in reserves. They are also being more conservative in their lending - partly because of Dodd- Frank and partly because loan demand remains subdued. The bottom line is that banks will continue holding excess reserves for the foreseeable future. It could take several years to flesh out the details on all the Dodd-Frank regulations and to boost economic growth and loan demand to higher levels. If Congress were to eliminate the IOER Federal Reserve tool, banks would go back to trading excess reserves among themselves. A bank with excess reserves would try to lend them to another bank that did not have sufficient reserves. In today s world, with so much in excess reserves, that process would drive short term interest rates down, perhaps back to near zero. And to fight a surge in inflation the Federal Reserve would have to sell assets rapidly to drain reserves from the system. Imagine the disruption on stock and bond markets that would cause; short-term interest rates collapsing, inflation surging and the bond market being flooded with Federal Reserve asset sales. Mark Calabria of the Cato institute says that anything that can be tagged as paying banks $50 billion a year not to lend will be politically unsustainable. While IOER is not an issue for stock and bond markets today, if nothing were to change in the world of excess bank reserves, it would become an issue in 2019. Hopefully the Federal Reserve will drain excess reserves by gradually selling assets and loan demand will increase as the economy gains strength. However, IOER is an issue for investors to understand and watch. I will have the next market review and update for you one week from today on Wednesday March 29, 2017. All the best,
John Dessauer March 2017