Weekly Commentary Overview
- Stocks got off to an abysmal start to the year, with both developed and emerging markets cratering.
- There were several catalysts for the market rout, but once again China appears to be the main focus of investor anxiety. Nonetheless, the reaction to the selloff in Chinese equities was arguably overdone.
- Beyond the global political and economic turmoil, U.S. investors are wrestling with two more prosaic challenges: Falling earnings estimates and the mixed-bag nature of the U.S. economy.
- The rapid decline in the Chinese currency, the Renminbi (RMB), is a larger threat, should it incite other countries to devalue their currencies as well. That still seems unlikely, as is the possibility that this marks the beginning of a bear market in the U.S.
The China Storm: Parsing Sentiment and Substance
Rough Start to 2016
Stocks got off to an abysmal start to the year, with both developed and emerging markets cratering. The Dow Jones Industrial Average plunged 6.19% to close the week at 16,346, while the S&P 500 Index fell 5.92% to 1,922, and the Nasdaq Composite Index declined 7.27% to 4,643. In fixed income, the yield on the benchmark 10-year U.S. Treasury fell from 2.27% to 2.11% as its price rose.
While China has been the focus of investor anxiety, it could be argued that the reaction to the selloff in Chinese equities was overdone. In fact, few U.S. investors would have exposure to the domestic Chinese stock market. It’s the rapid decline in the Chinese currency, the Renminbi (RMB), that’s a larger threat, should it incite other countries to devalue their currencies as well. That still seems unlikely, as is the possibility that this marks the beginning of a bear market in the U.S.
A Bevy of Bad News
Last week did not lack for bad news. Trading in mainland Chinese stocks was halted on two occasions when stocks fell more than 7%, the RMB continued to depreciate and a measure of Chinese manufacturing suffered its longest decline since 2009. To add to the anxiety, Saudi Arabia broke off diplomatic relations with Iran, and North Korea alleged to have detonated a hydrogen bomb, although most scientists dispute the claim.
The net result was a rout in global equities, with markets down between 6% and 7%. Other risky assets also suffered. High yield bonds sold off, although not by as much as the selloff in equities might have suggested, and oil hit its lowest level in more than a decade. Equity market volatility, as measured by the VIX Index, climbed back to the highs recorded in December. Meanwhile, investors piled into safe-haven assets, pushing Treasury yields down and gold higher.
Beyond the global turmoil, U.S. investors are wrestling with two more prosaic challenges: Falling earnings estimates and the mixed nature of the U.S. economy. Since the end of the third-quarter reporting season, fourth-quarter earnings estimates have fallen from 1% to -3.7%, and estimates for 2016 are down from 10.3% to 7.6%. Without the tailwind of monetary accommodation from the Federal Reserve, equity gains will depend on earnings growth. Therefore, until we see some improvement in earnings estimates, it will be difficult for U.S. stocks to make consistent progress.
Unfortunately, U.S. companies are facing several headwinds in their efforts to grow earnings. The strong dollar continues to be one obstacle. In addition, profit margins are likely to contract in an environment of firming wage growth.
The final challenge is the uneven nature of the economic recovery. On the positive side, the U.S. labor market remains strong. Last week’s nonfarm payroll report was a particularly market-friendly number with job growth at 292,000, well above expectations. Wage growth accelerated to 2.5% year-over-year, a bit below expectations, which actually helped alleviate concerns about an overly aggressive Fed.
However, outside of the labor market, things look worse. The December Institute for Supply Management report indicated a contraction in manufacturing; durable goods orders were negative to flat; and rail carloads (an indicator of business activity) are falling in a manner not seen since 2009. And with oil reaching its lowest level in more than a decade, the energy sector will continue to be a drag on earnings, at least through the first quarter.
Given the economic uncertainties in the U.S., global turmoil is the last thing investors need. But so far this year, investors have been experiencing a sort of "China Syndrome," if in reverse.
The China Syndrome
Given the economic uncertainties in the U.S., global turmoil is the last thing investors need. But it’s important to view events, particularly in China, in context. The selling in China last week began with another poor manufacturing report. However, while the number was weak, it was not dramatically out of line with expectations. But a significant contributor to the selling was the planned expiration of a ban on key shareholder selling that the government implemented last summer. In an effort to stabilize the market, the government quickly delayed the end of the ban. Unfortunately, neither the reinstatement of the selling ban nor the recently established "circuit breakers" intended to stop a freefall in stocks helped. By the end of the week, Chinese authorities conceded the circuit breakers needed more research.
While few investors outside of China have exposure to the domestic stock market, the bigger threat for global investors is the accelerating drop in the Chinese currency. On Thursday, the RMB was fixed at the lowest level since 2011. In addition, China’s foreign currency reserves dropped by $108 billion in December, a much larger-than-expected decline, renewing concerns over a more rapid depreciation in the RMB. This would raise the prospect of a more disruptive series of competitive devaluations among other nations. Although that is not our base-case scenario, if it were to occur, last week’s drop could be a prelude to a more serious equity correction. But we don’t view last week’s events as the start of a bear market, and believe the U.S. market reaction may be overdone. For now, the declines may have more to do with sentiment than substance.