Broker Check



The Cobra Effect

| September 25, 2017

The cobra effect, a phenomenon described by German economist Horse Siebert in his 2001 book of the same name, occurs when an attempted solution to a problem actually makes the problem worse in an instance of unintended consequences. It gets its name from an anecdote set during the British rule of colonial India; the venomous snake population was getting out of hand, and so the government offered a bounty for every dead cobra. In the short term, this drastically reduced the number of cobras, seemingly taking care of the problem. However, people began to breed the cobras for the reward, and when the government found out, the reward was dropped. All the snakes bred for the rewards were released, making the problem much worse than it had been when the reward was first offered. The cobra effect, then, is sometimes used to illustrate the causes of incorrect stimulation in economy and politics, and to illustrate the unintended consequences.

When I heard this story, I could not help but apply it to the current target-rich environment of unintended consequences the Federal Reserve finds itself in. This September’s rate announcement was the one of the most anticipated in my recent memory. The Fed had previously signaled that it was prepared to raise rates in 2015 and, had the international situation not been in the headlines, may have done so.  But the Fed chose not to increase, as "recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.” (FOMC Press Release).

Did the possible Federal Reserve rate increase cause the market action we’ve seen recently? Could it be that the market has simply priced in a rate hike and tightened financial conditions in anticipation of said rate hike? In my previous July email communications, we spoke about the Fed being on hold.

Partly due to the economy’s dependence on easy credit, I do not expect the Fed to raise the federal funds rate more than once later this year. Now, with the cover of Greece and the International Monetary Fund having announced on July 9th that they see a slowdown in global GDP, they have more than enough political cover such that there will probably be no interest rate increases until 2016.

The China currency devaluation, downshift in global growth, and the fact the Fed did not raise rates align nicely with this potential theory. Perhaps the markets are pricing in a tightening path, not just one increase.

As the market continues to search for a bottom, has the decline in US stock prices, and much more in emerging markets, been enough to accurately reflect the increase in the risk to earnings from a global slowdown? With the slowdown in China and the drop in oil and commodity prices, and a tightening US Central Bank (QE3 ended last October), there are bound to be some negative adjustments made… Are they priced in? I’m not so convinced.

In reading Barron’s September 7th cover story “Strong Market, Crazy World: U.S. stocks could rise more than 10% by year end, despite market turbulence around the globe.  Wall Street’s top strategists see more gains ahead in 2016.” I read that my views may be in the minority as all 10 of the strategists have a similar outlook. While they “seem less upbeat than in the past surveys, there is no dissent in the group on the markets direction: upward.” I would have thought that for sure some of the strategists would be predicting contagion. None are. 

Reasoning seems to be based upon how well the US economy is insulated from emerging markets. According the Barron’s article, “approximately 2% of the revenues of the S&P 500 constituents are generated in China, and U.S. exports account for just 13% of GDP, with less than 1% going to China.” That’s not a huge amount of exposure. For comparison, Canada is a much more important trading partner to the U.S. “accounting for 16% of total U.S. exports (in 2014).” 

So in a way the Fed has created a lot of snakes… it can’t raise rates right now partly due to the economy’s dependence on easy credit as evidenced the global financial market reaction created  by the threat of tightening (hiss). The solution to the unintended consequences of prolonged zero interest rates is proving itself to be a complicated one.

The economic forecasts set forth in the communication may not develop as predicted and there can be no guarantee that strategies promoted will be successful. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.