This time, it will always be different, but to the extent we can find clues from what we know as fact then we should, before the Fed announcement on 17 September.
1998 was a year …
… when oil prices had dropped sharply, around 40% in that case, during the previous two years (similar to today)
During the few years before 1998, US consumer inflation was falling due to importing lower costs from EM and cheaper oil/commodities (similar to today).
EM equities performance – as measured using the MSCI EM index – had already gone through three years of volatility and no returns, what I call the investor saturation period (similar to today)
Within this strained EM environment, geopolitical risk was on the increase (similar to today). Al-Qaeda and Bin Laden gained wider terrorist notoriety around this time with the US embassy bombings in 1998. This ultimately led to the horrific September 11 2001 attacks and the Afghanistan and Iraq wars.
Around the start of 1998, EM equities went from volatile, range-bound movements to falling sharply (similar to today).
Developed equities had been going strong for a good few years previously, well into a long bull run up to and including 1998 when EM had already started to drop (similar to today).
The US Fed, run by Alan Greenspan, had a strong doveish bias, and had been holding from increasing rates – despite the equity bull market – because of falling inflation, and therefore there had been a period of three years of broadly flat-ish Fed rates to 1998 (similar to today).
The dollar had been strengthening for three years (similar to today).
Unemployment rate in the US had been clearly trending down for a few years and even in mid-1998 wasn’t showing signs of stopping (similar to today).
There are a lot of rhymes here. What happened next?
Around mid-1998, the highly levered LTCM fund failed, linked to Russia’s default. The perceived systemic importance of LTCM’s activities meant that developed equity markets suddenly started following EM down during the middle of the year and the S&P had a 20% drawdown. Greenspan in quick doveish response, cut rates by 25bps each month for three months consecutively, giving a substantial 75bps liquidity boost.
This had the effect of causing the S&P to bounce quickly and within two months had recovered all of the 20% drawdown, and started a further strong run up in equities. This ultimately became the infamous dotcom bubble the following year.
EM equities however still had another 30% drop from this point in 1998, even given the highly accommodating Fed, before starting to recover. The overall drawdown for EM from peak to trough turned out to be a very painful 60% loss.
EM did recover (almost) by 1999 when the world was well into the dotcom craze, but unfortunately before there was time to fully recover, the global dotcom bust/recession hit and EM equities fell hard again along with developed equities.
The 1998 Greenspan 75bps rate cut has, in hindsight, been blamed for starting the dotcom boom and therefore causing the painful recession of 2000-2002.
The Fed won’t do anything like this again. Even though many macro indicators are similar to 1998, Greenspan isn’t running the Fed. Yellen would need to start another round of QE in the US to emulate the 75bps rate cut, and that will not happen unless job growth / profits stall significantly and the trend of these two indicators aren’t bottoming out yet. There’s little chance of an exciting 1999-era late-bull bubble this time.
The opposite – of increasing rates in this situation – would have been unthinkable in the Greenspan era, and yet this is what Yellen and the Fed are considering now. Yellen will not make a mistake similar to Greenspan (being blamed for causing a bubble to inflate over the next year), but also, the Fed won’t want to be remembered for triggering the next global recession, either.
These two strong counterbalancing motivations mean the Fed will likely be bound to flat rates and the equity markets will be volatile on reading yo-yoing expectations going forward.
Add to all this mix of uncertainty over whether ECB can overcome the EU political quagmire to provide well-timed and well-targeted liquidity, instead of it coming from the US Fed, and we should all get ready for the wild ride to continue. At least we won’t have persistently low volatility any more.
Chi Lee
