Market Commentary

Unintended Consequences Are Here

January 2015

"The problem of unanticipated consequences of purposive action has been treated by virtually every contributor to the long history of social thought’ " – Robert Mertonⁱ

We have arrived in the unintended consequences. We’re now years into stock markets stimulated by massive monetary interventions all over the globe, a stimulus that was initially launched to repair the confidence lost during the global financial crisis.

Curiously, the first documented use of the idea of unintended consequences is linked to interest rate policy. Philosopher John Locke wrote to a member of the British Parliament in 1691 and encouraged Parliament to not set a low interest rate because Locke believed it would create the unintended consequence of being ‘a Prejudice to none but those who most need Assistance and Help,’ and ‘mightily encrease the Advantage of Bankers...and other such expert Brokers.’ⁱⁱ How far we’ve come – these are the same critiques that have been laid at the foot of central bankers around the world during the past several years.

Two things happened towards the end of 2014 that we think have set the stage for an increasingly turbulent time as we enter 2015. First, the US Federal Reserve has continued to indicate that it plans to raise interest rates this year, making the dollar a more attractive currency (because it will have a yield again). This move also differentiates the US central bank from other central banks around the world, most notably those in Europe and Japan, who will likely continue on a stimulus course. The rally in the dollar, and the divergence of central bankers’ actions, we think is likely to cause disruption. Remember, we are in uncharted waters for our generation, because it is a highly unusual circumstance for such a small set of decision-makers to have such a dramatic impact on the global economy – and these decision-makers have been acting mostly in concert with each other during the past six years.ⁱⁱⁱ As these bankers move into potentially countervailing actions, we figure there will be more surprises.

Second, the monetary stimulus here and elsewhere led to a lot of cheap money chasing return, much like it did in the late 1990s and during the period leading up to the financial crisis in 2008-2009. Two of these more recent ‘hot money’ chases ended in remarkable flows of foreign investment into emerging economies overseas (predominantly in the fixed income markets), and into the capital-intensive development of shale-oil production in the United States. As the US Federal Reserve indicated that it would begin to raise interest rates on the dollar, foreign investment began leaving some of the emerging economies in search of safer pastures, prompting slowing growth there and some sharp reversals in currency valuations, some desired by their governments and some not, and the emergence of inflation in some of these countries and deflation in others.

As new US oil production came online, it created supply growth in the global oil market just as demand for oil began to come off its peak due to slowing global growth. This was exacerbated by OPEC and Saudi Arabia’s decision on Thanksgiving Day to continue oil production full-bore, possibly intended to make new US shale oil unprofitable (if all oil is cheap, the logic goes, new US development and production may be selectively abandoned, thus dampening supply and improving OPEC and Saudi Arabia’s long-term market position). Add to that the geopolitical tensions of a world newly threatened by an aggressive Russia, but which is weakened because its economy is so heavily impacted by the price of oil. So, the upshot is a true collapse in the price of oil – oil is less than half the price it was six months ago. Only some of this price collapse is based on the fundamentals of supply and demand, and the impact has been destabilizing on many markets.

Three years ago we pulled your portfolios back into a more conservative posture because we thought the unintended consequences of central bank actions around the world could be inflation and no growth – which is not good for stocks.^iv As a measure oriented toward capital preservation, we held your portfolios more conservatively for a time. Now, we are staring at an oil price collapse and think it’s possible we could be near some end game of having the exact opposite, at least in the US, for awhile: deflation and accelerating growth in the US. Even as we remain somewhat skeptical about the long-term inflationary impact of aggressive monetary policy – we will have to pay the piper sometime - we have emphasized, over the course of 2014, building new core stock manager allocations, and adding to existing ones. We’ve also lightened up on gold-specific hedges where appropriate. Your core managers work to balance opportunity and caution in the way they seek gains for you, and while they have generally underperformed the US stock market, they’ve fared reasonably well against stock benchmarks overseas and are ready to pounce as opportunity develops. Expect more emphasis on our core managers in 2015, even as we also continue to do our homework on more opportunistic possibilities in emerging markets, and a few contrarian investments that are small allocations in some portfolios.

We encourage an ongoing dialogue with you about what’s coming and how we have put money to work for you. We think the ride could get a little bumpy this year, and we are working to create the best long-term outcome possible for your investments.

This is a general assessment of client portfolios and does not reflect the specific circumstance of every client.

i “The Unintended Consequences of Purposive Social Action,” Robert K. Merton in The American Sociological Review, Vol 1 No 6, December, 1936.
ii See ‘Some Considerations of the Consequences of the Lowering of Interest and Raising the Value of Money,’ letter from John Locke to Sir John Somers, November 7, 1691, available at http://oll.libertyfund.org/titles/763
iii Arguably, the last time this was the case was in the 1920s. For an excellent history of a similar time, read Lords of Finance: The Bankers Who Broke the World, by Liaquat Ahamed
iv For a good example of this argument see “The Law of Unintended Consequences: The Worst Mistake in Decades,” Jeffrey Sica in Forbes, Feb 28 2011