There was no Santa Claus rally in 2015. In the last few weeks, the market has done poorly, with the S&P 500 falling 1.75 percent in December and another 4.9 percent in the first four trading days of 2016, the worst start to a new year in the history of the index. The U.S. labor market is strong, and consumers seemed to have opened their wallets and purses for the holiday season (retail sales up over 7 percent and auto sales at an all-time annual record). So what’s eating at Wall Street?
There are several issues on traders’ minds. Some pundits believe that a recession is imminent because manufacturing in the U.S. now seems to be contracting and because the oil industry is clearly in disarray. Others are worried that China will have a hard landing, that they will depreciate their currency, or that their volatile stock market will translate to their economy. Still others believe that the Fed was too accommodative for too long, causing the equity market to rise too rapidly, leaving it overpriced. That’s a lot to be worried about.
There is no doubt that U.S. manufacturing is the victim of the mercantilist policies of most of the rest of the world. Allowing the dollar to strengthen by an average of 15 percent versus the rest of the world puts U.S. manufacturing exporters at a huge disadvantage as it it reduces foreign demand for U.S.-produced goods, and, at the same time, also reduces domestic demand, as foreign capital equipment is now cheaper. No wonder Wall Street is worried!
Ironic – for years the U.S. has desired to be oil-independent. And right at the point of such achievement, OPEC and the Saudis decide that an oil price war, to drive the marginal American oil producer out of business, was in their best interest. (The price war, by the way, is quite beneficial to the U.S. consumer.) From an economic viewpoint, however, their ploy will ultimately fail:
- Saudi Arabia currently is running an unsustainable 20 percent deficit/GDP ratio, which can’t go on very long
- Fracking technology will act to keep the price of oil relatively low over the long term, because if higher oil prices appear to be permanent, then the higher-cost oil from fracking can once again profitably enter the market
On top of all of this, the Middle East has become a hotbed of instability with ISIS now in Libya, Yemen, Syria, and Iraq. And now, North Korea claims to have a hydrogen bomb. No wonder Wall Street is worried!
Most of the worldwide slowdown in 2015 was caused by China’s infrastructure-oriented economy. Now that China is switching to a more capitalistic consumer-led economy, there is much less demand for raw materials and heavy manufactured products that are part and parcel of infrastructure projects. Wall Street continues to worry about a hard landing in China. But the consumer economy is really doing well, and a 6 percent rate of growth a there, in the world’s second largest economy, is hardly a hard landing! Wouldn’t the U.S. relish that growth rate?
But now that China’s currency is part of the IMF’s currency basket, a long-sought Chinese goal, Wall Street is worried, and rightly so, that they will become “mercantilistic” and depreciate their currency for their own advantage. This appears to be happening as we enter 2016. Unless there is a U.S. policy response (doubtful), the dollar will strengthen against the Chinese yuan, causing even more pain in the U.S. manufacturing sector.
Wall Street is also worried about volatility in China’s equity markets, as the two major exchanges there were in meltdown mode the first week of January. Much of this has been caused by government interference and bungling in the markets. As of Friday, the circuit breakers that were put in on Monday, and were likely responsible for the selloff, were lifted. That market will soon find a bottom now that it is free to fall without restraints. The good news is that in China today, there is very little correlation between the real economy and their equities markets.
The seven years of the most accommodative monetary policy in history has likely played a large role in the outsized equity market returns over that time horizon. Today, after the first rate hike, and with the Fed’s stated intent of raising four more times in 2016, the equities no longer have the crutch of such aggressive accommodation. Wall Street is worried about such overvaluation.
Eighty percent of the U.S. economy, the services sector, is strong. Jobs are plentiful. A recession doesn’t appear to be on the near-term time horizon, and it’s recessions that cause equity bear markets. If the manufacturing and oil sectors were healthy, economic growth would top 4 percent. But because they aren’t healthy, and because of various issues in China, economic growth will be slow, but still positive. In addition, because the Fed stayed too easy for too long, some on Wall Street think that the equities markets may be overpriced. Two things are apparent for the equity sector: 1) market volatility will remain heightened for the next few months; 2) 2016 will be a stock-pickers market, and passive market strategies may not do as well as active ones.