Risk and Uncertainty, Confidence and Fear

In recent weeks, the financial markets appear to have been reacting less to weaker expectations of global growth and more to the increased downside risks – that is, to the fear that things could get a lot worse. The downside risks to Europe are considerable, but America is much less dependent on exports than most other countries and the prospects for moderately strong growth into 2015 remain promising.

Students of forecasting learn that there are two parts to any projection. There’s the point estimate, the expected value at a certain point in the future, and there’s the uncertainty around that point forecast. In economics, that forecast uncertainty is often embarrassingly high and usually isn’t symmetric (meaning that downside risks could be a lot different than upside risks). That doesn’t mean that forecasting the economy is a useless effort. It’s just that one should take such forecasts with a grain of salt. It’s far more important to develop a consistent story and look for ways that the story could go wrong.

Similarly, investors typically face a given set of expectations, while the risks surrounding those expectations can be quite substantial and may increase or decrease over time. Recently, the IMF lowered its outlook for global growth in 2014 and 2015. That should have surprised no one. What has been troublesome for the financial markets is that the downside risks to that outlook have increased. Europe has faced important challenges over the last few years, but the current phase, as it battles the threat of deflation, is expected to be more difficult. Inflation is low in the euro area and the European Central Bank’s policy rates are near zero (and in the case of the rate on the deposit facility, a bit negative). The ECB has to do more, and that means quantitative easing. However, there may be legal challenges.

Europe has been an on-again off-again concern for U.S. investors in recent years, mostly reflecting concerns about the survivability of the monetary union. Those fears were put to bed when ECB President Mario Draghi promised to do “whatever it takes.” Yet, austerity efforts in Europe have been self-defeating and growth has slowed. While the U.S. economy still has a long way to go, we have remained firmly on the recovery track, with few signs of the types of excesses that would lead to an economic downturn. After a while, U.S. market participants have repeatedly put aside their worries about Europe. This recent focus on Europe may not be much different. Worries about Europe could lead U.S. firms to pull back on hiring and capital expenditure plans. However, foreign trade is much less important to the U.S. than it is to other advanced economies. Trouble in the rest of the world may have a significant impact on some U.S. firms, but it’s not expected to have a large effect on the domestic economy as a whole.

One side effect of a soft global economy is a strong U.S. dollar and downward pressure on commodity prices. That should be helpful for consumers. Along the usual seasonal pattern, retail gasoline prices can be expected to fall about 12% from May to December. This year, they’ve fallen about 13% so far, with further declines expected in the weeks ahead. That’s somewhat supportive for the consumer spending outlook, but not enough to boost sales activity sharply for the holiday shopping season. The impact of lower gasoline prices depends on the magnitude of the decline and how long prices remain low.

As Fed Governor Stanley Fischer recently noted, monetary policy, while focused on the outlook for the job market and inflation, must consider what’s happening in the rest of the world and take into account the feedback from abroad in reaction to any policy changes. The downward pressure on inflation is likely to contribute to a delay in the Fed’s initial increase in short-term interest rates. Indeed, most private-sector economists are likely to push out their forecasts of the timing of the first rate hike. Some are suggesting that the Fed may even want to delay the end of QE3 or introduce QE4. That is unlikely. Remember, QE3 was meant to impart positive momentum in the economy, especially in the job market (mission accomplished). Officials believe that asset purchases are less effective over time and potentially more risky. So QE4 isn’t going to happen unless the economy takes a serious turn for the worse, and there’s not much chance of that.

The exaggerated fears of Ebola are a good example of the difficulties in defining downside risks. Your chances of contracting the Ebola virus are extremely low. You are much more likely to die of the flu than Ebola (and, as an aside, you can reduce that risk by getting a flu shot). Yet, Ebola fears played a role in last week’s market volatility. One recent survey showed that 25% of Americans are worried about catching Ebola. If 10% of those people decide not to travel, then you’re talking about a 2.5% reduction in air travel (that’s assuming that the 25% are a representative sample of potential travelers, which is a leap). Granted, this is a crude (and almost certainly wrong) estimate of the impact, but it gives you an idea of how a panic can begin to affect the economy. Most likely, the cable news stations will eventually find something else to worry about.

Friday’s rebound in the stock market was encouraging, but we may still see an elevated level of market volatility in near term. This week’s economic calendar is not going to have much of an impact on the overall picture, but the following two weeks will be a lot more eventful, as we get some indication as to where the U.S. economy is heading in the near term. Mostly, the outlook will remain moderately positive, especially in comparison to the rest of the world. Investor confidence should improve.

© Raymond James

© Raymond James

Read more commentaries by Raymond James