What’s going on?
That’s the question many people – not just traders and investors – are asking as the ructions of 2016 have continued into their third week.
Beneath that simple three-word phrase is a much more difficult query: what changed between the end of December and the first few trading days of January to lead traders and investors around the world to so fundamentally change their outlook for the year ahead?
The S&P 500 in the US is down 8.5% so far this year. The price of crude is 19.7% lower than its 2015 close and the Kazakh Tenge, the official currency of Kazakhstan and one of just a number of emerging market currencies getting hammered in 2016, is down a little around 15%. The ASX 200 has already lost 7.5% for 2016 and it’s a similar story on other markets around the world.
Malcolm Gladwell might say that markets have passed a “tipping point”. A scientist familiar with thermo-dynamics might posit that investors have just passed through a “phase transition”, like water does when it suddenly changes from liquid to solid. The father of fractal finance Benoit Mandlebrot would simply tell us that “continuity is a fundamental assumption of conventional finance” but he’d add that “the math is wrong” and markets suffer these types of “dislocations” more often than finance theory cares to admit.
Each of these potential explanations highlight that it may not be a fundamental shift in market thinking that has driven this year’s market ructions.
Rather, it’s just that more traders and investors have become pessimistic about China, corporate earnings, global growth, and the commodity outlook. By doing so, this small cabal of newly-converted pessimists have been enough to bring about the market’s tipping point.
On the other hand, it’s possible this is being driven by something more fundamental and that we’re seeing a start of a more prolonged downturn in financial markets.
What’s not arguable is that it’s here and fairly complex, involving a range of issues. So for those who are wondering, what follows is an attempt to explain it.
1. The US Federal Reserve’s interest rate outlook for 2016 and the impact on emerging markets
The US Fed’s first rate hike in nine years was as well-telegraphed to the market as any interest rate move ever undertaken by a central bank. By doing so the Fed hoped to avoid the market ructions and stock market selling that such a move could unleash after a long period of zero interest rates.
To help markets adjust, the Fed also releases a “dot-plot” chart which summarises the FOMC members’ views of where rates will be over each of the next 3 years. Again in doing so the Fed hopes this layer of transparency allows traders to prepare for the coming rate hikes – at least the ones the Fed expects to deliver.
But the four rate hikes the dot-plot implies, and more importantly, the consistency with which Fed governors have reiterated that they are going to implement such a rate hike path so far this year, has weighed on markets.
But not just developed markets.
Emerging markets, which have built up substantial debts denominated in US dollars, are also under pressure. That’s because investors are both worried about the impacts of a rising US dollar on emerging market currencies and on the debt pressures for emerging markets.
Add in continued concerns about Chinese and global growth and emerging markets are in a very tight negative feedback loop.
But we saw in September, when it abandoned a well-telegraphed intention to raise rates, that the Fed is not immune to “conditions abroad”.
George Soros said in Davos this week he’d “be surprised if the Fed raised rates again”. Any sense the market gets that Soros might be right – and that the Fed is willing to hold fire – could calm a few nerves and send markets roaring higher.
2. China’s currency weakness and its economic slowdown
The outlook for global growth may not be anywhere near as parlous as recent market moves would suggest. The crashing oil price is certainly hurting energy exporters but it is a boon to the growth outlook for many more nations.
As the economy which was the global growth engine in the post-GFC era, a Chinese slowdown is a challenge for markets. This week China released its GDP data which showed a clear slowing of growth momentum. The question, as Ray Dalio, who manages the world’s biggest hedge fund, posed it at Davos this week is where the new engine of growth will come from.
Already leading indicators of economic growth suggest a sharp slowdown in Chinese growth to 6% across the course of 2016.
But Chinese authorities are not standing idly by. This week they have pumped 400 billion yuan into the banking system, the biggest injection of cash in more than 3 years.
On the currency front they are letting the yuan weaken while at the same time managing its depreciation in such a manner as to not increase pressure on their own markets and those abroad.
This weakening of the currency means Chinese exports will be cheaper for everyone else, but this brings its own problems. Other nations end up “importing deflation” from China, at a time when inflation is running low anyway. (More on that in a tick).
Even as it devalues against other currencies, money is still trying to exit China at a startling rate. A turnaround in either the growth outlook or the capital flow position is hard to see anytime soon. Perhaps the best traders, and Chinese authorities, can hope for is a release of current pressure.
3. Tumbling oil prices are playing havoc with inflation
Mario Draghi, the ECB president, has promised more easing in Europe as a result of the weakness in inflation expectations and the outlook for global growth.
But it is low inflation that he fears because of the impact it can have on consumer behaviour and thus economic activity.
A lack of inflation means there is little penalty to a consumer or business who puts off a purchase today, this week or this month, because they don’t expect the price to increase much, if at all, over that time period.
Indeed the constant leap forward of technology in many areas of commerce suggests there is a reasonable expectation that a delay could be met with cheaper prices.
That’s potentially poisonous to economic growth because a purchase delayed is economic activity lost during that period. This keeps growth lower than potential output, increasing the chances of job losses, while the output gap itself can then reinforce deflationary pressures. It can be a vicious, and negative, cycle.
So with losses of close to 20% so far this year, the falling price of oil has been a large driver of the market fears about growth and inflation.
While markets are focused on the negative, there is little attention being paid to lower fuel prices and the effect they can have on consumption and spending, as they act as de facto tax cuts, putting more cash into consumers’ pockets to spend on other goods.
Consumers may not be focused on the positives, however, as they look at what’s happening on markets.
Should oil turn, and should comments in Davos by Saudi Aramco chairman Khalid Al-Falih that “the market has overshot on the low side and it is inevitable that it will start turning up”, be proved correct then the outlook for inflation, and thus consumption could turn.
At least, that’s the idea.
4. Stocks in advanced markets have become expensive
Australian billionaire money manager Kerr Neilson said recently that “valuations in so-called developed markets are high,” and companies in these markets are vulnerable to the attacks of China’s “underutilised factories” which will “try to find markets abroad.”
This recognition is a big part of why he believes markets have been sold down in January.
Valuation is a theme that BI founder Henry Blodget has warned about on multiple occasions in the past year. With an eye to these valuation metrics he recently wrote that a “stock-market crash of 50%+ would not be a surprise — or the worst-case scenario.
But Blodget’s warnings, like Kerr Neilson’s – and many others – have fallen on deaf ears until recently. What’s changed is that all of the above coalesced into a narrative that appeared far stronger than the previous market belief that low global interest rates and central bank quantitative easing would keeps stocks higher, despite the dilution in growth in earnings and revenue from a difficult economic landscape.
What happens when traders all wake up thinking a similar thing at a similar time? They rush to the act on that thought.
This year, traders have been selling assets and diluting their risk of losing money.
This race to exit the building as someone calls “Fire!” is exactly the type of fear driving markets lower in 2016.
It’s lead some pundits, like Peter Tchir from Breen Capital in the US, to warn that much bad news is already priced in be cause of this acute fear.
I think the market is now pricing in a lot of bad things happening, possibly all at once. Positioning is extended to oversold. Bearish sentiment abounds.
As the market prices in more and more bad things happening, it starts missing the odds that NOT all of the bad things will happen.
That’s a fair bet, one that many traders might take very soon.
But George Soros has a warning for these tactical bulls. “You could have a bounce here (in stocks) but this is not a good entry point,” he said in Davos this week.
We’ve all been warned.
One thing that’s clear is that the confluence of the above factors means the weakness in 2016 feels very different to 2014 and the 2015 selloffs.
So it’s likely we need either a further big fall to clean out the optimists and satisfy the pessimists. Or we need a period of stability so some of the optimists who have been spooked into the pessimistic camp can move back toward the optimistic end of the spectrum.