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September 2015: As anyone in the community of investors has already known for a couple of weeks, the stock markets dipped solidly into correction territory, ostensibly as a result of the Chinese currency devaluation. Our own opinion is that the markets were in elevated territory, and when that is the case, almost any relevant excuse can be used to trigger corrective moves. We discussed this in our blog after the first down draft occurred, with some guidelines for where the S&P500 should expect to encounter support and resistance. However, the economy in general, is in an otherwise good state. GDP growth continues at a moderate pace, unemployment continues to move slowly downwards, and inflation has not yet returned up to the levels which the Fed prefers to see over the long term. Deflation continues to be a whispering threat, but should disappear completely if unemployment dips below 5.0% by the end of the year. The Fed will meet this month again, and let the country know if they believe things are strong enough to begin to move interest rates upward. We see action this month by the Fed as now being a 50-50 chance of beginning with a token raise of interest rates. The stock markets have already corrected, so a token increase may now indicate to the markets that the Fed does have enough confidence in the economy to begin to the process of restoration to normal. They will weigh this against any probability they see as the rate hike causing any further spooking of the market, and triggering a deepening of the correction, which in turn affects consumer confidence, spending, etc. But there are no existing overheated economic sectors, and energy is still very soft, and likely to get even softer. Long term, the remainder of the economy benefits when less cash goes toward the support of combustion, and more into capital available for constructive pursuits and discretionary spending. If the Fed does raise rates, we would expect the stock markets to retest recent lows (S&P500 back to the low-to-mid-1800's). Conversely, a no-go for the rate hike this month could support a relief rally for another few weeks, until the October guess-what-the-Fed-will-do-next game begins. This cycle could go on for months, into the first quarter of 2016, to a point where the uncertainty itself begins to have negative effects on economic confidence. As a consequence of this short term uncertainty, coupled with the corrective move in the markets, we have increased our recession probability to a bit over 1 in 5. To us, this is still not a call for action, yet it is a call for increased vigilance. Nervousness and volatility are going to be more prevalent in the coming months, and there are budget politics afoot in Washington between now and October 1.
We believe that good news would need to come in three forms for the markets to shake off the correction and resume modest upward movement again: First, the Fed would need to say that they are now convinced that the economy is on solid ground, and picks a date in the near future, at which time they will begin a fairly predictable interest rate set of interest rate hikes. "Telegraphing" intent tends to allow people and market mindsets to adjust to the concept of things changing, without inducing panic when changes actually happen. Second, cool heads will prevail in Washington, and reasonable and bi-partisan agreements are made to extend the debt ceiling, pass a budget which is non-punitive to any segment of society, or at least a continuing budget resolution, all so as to avoid even the hint of another government shutdown. Finally, the markets themselves will resist any panic-over-nothing responses, and at worst, trade sideways for several weeks. Granted we may be hoping optimistically here, but if these do come about, then overall economic confidence and activity can continue to improve, and recession probability could recede to sub-10% again soon. That end result is primary goal of Federal Reserve policies, after all.