The selling Friday started in China as fears of a slowdown in economic growth in that country intensified worries that the global economy was headed for a serious slump.
On a big picture level, the flash manufacturing purchasing managers index from Caixin/Markit economics dropped to 47.1 in August from 47.8 in July. (Anything below 50 indicates contraction.) The drop in the sector index was the fastest decline in six years and marks the lowest level since March 2009. On an industry/sector level market research Gartner reported that quarterly sales of smartphones had dropped for the first time ever.
The immediate result was a 4.3% drop in the Shanghai Composite Index. At Friday’s close of 3507.7 the index is again deep into bear market territory with a decline of 31.5% sine the June 11 high of 5121.6.
It didn’t take long for fears of slowing growth in China to ripple out across global markets in everything for oil (U.S. benchmark West Texas Intermediate fell another 2.17% at the close to $40.45 a barrel after trading a low as $39.86 a barrel in intraday trading) to technology. Apple (AAPL) let the U.S. technology sector lower with a 6.1% retreat (pushing the stock into bear market territory with a 20% decline.) The semiconductor sector fell into a bear market too. Technology momentum stocks, such a Netflix (NFLX) plunged. Shares of Netflix dropped 7.6% on Friday. Internet security high-flyer FireEye (FEYE) retreated 8.1%.
The Dow Jones Industrial Average fell into 10% correction territory from its May high. The Standard & Poor’s 500 stock index finished lower by 5.5% for the week.
That’s all history, of course—although it is very recent history. What you want to know now is where stocks go from here.
Start with a recognition that the drop of last week (and not just Friday) has done considerable damage to the structure of global stock markets. Sectors all across the U.S. market—biotech and media, as well as semiconductors–are in correction, which always raises fears that a 10% correction will turn into a 20% bear market drop. U.S. stocks have clearly broken out of the narrow 150-point trading range that has dominated the year—to the downside—and major markets are setting major lows. The NASDAQ Composite index, for example, made a six-month low. Individual U.S. stocks have fallen below support at 50-day or even 200-day moving averages and market leaders such as Apple are in bear markets. (I’d add in the huge bear market drop in Alibaba (BABA) on the New York market with shares down 42.8% from their November 10 peak and down 26.9% from the May 22 high.) Indicators such as the CBOE VIX volatility index soared last week with the VIX climbing 46% to 28.03 (a 118% gain for the week) as lots of investors and traders bought options to protect their portfolios. If nothing else that’s an indicator that traders are looking for continued high levels of volatility in the weeks ahead of the September 17 meeting of the Federal Reserve.
Add in a bear market in emerging markets that has continued to punish the usual suspects (Brazil and Malaysia) and that continues to suck in new victims. The Turkish lira, for example, finished the week at historic lows against the U.S. dollar.
Factor in what looks like a lengthy period of confusing signals about growth. It’s likely to be quarters before growth in China rebounds or at least settles down enough so that traders and investors stop worrying that this locomotive of the global economy isn’t about to suffer a train wreck. Most forecasts for the next few quarters point to China’s growth falling to 6.8% or less, significantly below the official target of 7%. There’s nothing wrong with 6.8% growth—except that once traders see the Chinese economy breach 7%, it’s going to take a few quarters of 6.8% or 6.6% growth to convince them that 6.8% isn’t a prelude to a descent to 6.4% or 6.2% or even lower. Fortunately, there’s a good chance that the next quarter or two will produce stronger growth data in the United States. Number crunchers who look study the way that later data moves preliminary reports of GDP growth up or down say there’s a reasonable chance that the 2.3% annual growth reported so far for the second quarter will get revised upward when more complete figures and a new GDP growth rate are reported on August 27. The upward revision, some economists say, could be as high as full percentage point. Investors and traders will get their first read on third quarter GDP growth On October 29. (After the Fed decides on interest rates in September, by the way.) On August 18 the Federal Reserve Bank of Atlanta released its latest forecast for third quarter GDP growth. The Atlanta Fed forecast just 1.3% growth—which certainly seems disappointing, until you realize that this forecast is up from 0.7% in the August 13 forecast. There is the possibility that the trend is running toward higher growth and that we’re looking at better than expected growth in the third quarter. Growth of better than 3% on revised numbers for the second quarter and something above 2% for the third quarter for the U.S. is going to look pretty good in a slow growth global economy and those also going to say that there’s another growth engine available besides China. Of course, we won’t actually have the data to dispel fears and back up hopes until the end of August and the end of October.
Finally, those two dates for more GDP data neatly bracket the September decision to raise interest rates of not by the Fed. It’s hard for me to see markets settling down until after that Fed decision. Until then worries about will the Fed, won’t the Fed will be, at the least, a significant amplifier for worries about global growth.
I can’t say that global markets are going lower from here with certainty. The trends—worry about growth in China and in emerging market economies, worry about a war of competitive currency devaluations, worry about U.S. economic growth, worry about a Federal Reserve interest rate move (and worry about the possibility of a lack of a Fed move)—all seem to point lower. (And I haven’t even mentioned the continued rout in commodities.) And don’t see any immediate upside trends until we get data in the fall or later on growth in the United States and China.
The prognosis, in my opinion, is continued volatility that nets out to a drift lower for global equities including the U.S. markets until the September Fed meeting.
It’s not just the 2.1% drop in the Standard & Poor 500 today, August 20.
Or the fact that the index is now down for three straight days.
Or that the S&P 500 broke below its recent trading range.
Dig down a level and you’ll find plenty of signs that this market is profoundly nervous. That doesn’t mean we have to move into a correction but it does create a danger that something relatively minor will set off a major move to the downside.
What are the signs of anxiety that I’m seeing?
First, the severe swings in sentiment that greet relatively minor changes in fact. Yesterday, Wednesday, August 19, for example, odds of a September interest rate increase from the Federal Reserve swung from 50% down to 36% after the release of Federal Reserve minutes from the central bank’s July meeting. It isn’t just that the minutes were old news with views formed by old data that didn’t give any real new insight into the likelihood for the first rate increase since 2006. It’s also the size of the move in opinion. A move from 50% down to 36%, according to the Fed futures market is of a magnitude that shows how uncertain markets are.
Second, we’ve seen a huge decline in the ratio of puts to call options. Calls, which pay off if stock prices climb, have fallen by 36% by volume since January. Traders are spending the most on puts, which profit stocks when decline, since October 2014, when the S&P fell 9.8% and almost entered correction territory.
Third, about half of the S&P 500 stocks are trading 10% of more below their 52-week moving average. But even more significant to my mind as an indicator of market sentiment, I’m seeing selling focus on high-multiple growth stocks. For example, while the S&P 500 was down 2.1% today, Internet security high-flier FireEye (FEYE) dropped 8.4%. FireEye trades at 11.25 times revenue—the stock doesn’t have a PE since it doesn’t have any earnings.
And, fourth, what would otherwise be minor events have become big stories because they fit into themes that are at the top of market worries. Vietnam, for example, devalued the dong for the third time this year today. Big news? Only because every trader in the world is worried about an outbreak of competitive devaluations after China devalued the yuan. The devaluation of the dong could be an early sign of a current war among Asian exporters, according to this world view
As I’ve been writing lately, I think we’re going to see a lot of volatility ahead of the September Fed meeting. Buckle your seatbelts.
So much for calm.
Today, August 18, volatility returned with a vengeance led by a plunge in China’s mainland stock markets. The Shanghai Composite Index dropped 6.15% overnight. The Shenzhen Composite tumbled 6.56%. And the ChiNext market dominated by technology companies and startups fell 6.08%.
That put downward pressure on global markets for equities—as of 4 p.m. New York time the Standard & Poor’s 500 was lower by 0.32% and the German DAX was off 0.22%. And for commodities with the Brent crude benchmark down by 0.45% to $48.52 a barrel; gold lower by 0.19%; and copper in retreat by 1.55%.
What happened to cause the rout? Nothing really. Investors and traders who had decided last week that stimulus from the Chinese government and a devaluation of the yuan would be enough to push China’s economic growth rate above 7% changed their minds. Today they aren’t sure that these government measures will be enough or that the government will follow through with more stimulus to support these initial steps.
With that change of mind came a bout of profit taking as traders and investors decided to sell to lock in gains since Shanghai stocks bottomed on August 3. Data from July suggests that it’s the bigger and presumably more experienced traders and investors who are leading the profit taking. The number of investors in China with at least 10 million yuan in stocks dropped to 55,000 in July from 76,000 in August. The ranks of investors with 1 million to 10 million yuan in stocks fell by 22%, according to the China Securities Depository and Clearing Corp. That leaves more of the market’s trend in the hands of relatively inexperienced investors and traders with little experience of bear markets.
Three bits of news helped turn the consensus negative. First, data showed that a recovery in home prices is spreading. It’s likely, today’s consensus says, that the People’s Bank won’t move strongly on stimulus if real estate prices are in recovery. Second, the People’s Bank injected cash into the financial system through its regular weekly open market operations. The consensus today says less chance of a reduction in bank reserve requirements if the central bank is adding cash to the system. And third, securities regulators reminded the market that China Securities Finance Corp. the government’s vehicle providing cash to support stock prices, will reduce its buying of shares as volatility retreats.
Today’s drop, following hard on the heels of last week’s rally in mainland markets shows how little fundamental underpinning Chinese stocks have at this point. Last week’s upward move was founded on a belief that the Chinese government would strongly intervene to support stocks and the economy. Today’s retreat is based on a reversal in that speculation.
Until we see some data to show what the growth trend is, markets are at the mercy of these shifts in speculation.
Stocks and bonds don’t have memories. But traders and investors do.
Remember that as you try to figure out the next step in market reaction to China’s devaluation of the yuan.
On one level the People’s Bank’s move to extend the daily trading range of the yuan by 1.9% isn’t an especially big deal. Yes, it does mean that the yuan can sink further and faster—which it has in recent days. Today, Thursday, August 13, the yuan closed down another 0.2% to 6.399 to the dollar in the spot market in Shanghai. That brings the drop so far this week to 3%. Back at the beginning of the year it took 6.2077 yuan to buy a dollar.
But by many calculations the yuan had become increasing over-valued in 2015. The real effective exchange rate, an exchange rate adjusted for inflation and weighted by China’s trading partners, was up 13% over the last four quarters. The yuan was overvalued by about 15% before the move, according to calculations by the Royal Bank of Canada. The People’s Bank had spent about $300 billon of its huge foreign exchange surplus over the last 12 months to support the yuan against a climbing dollar in an effort to prevent outflows of cash from China and as part of China’s campaign to win recognition for the yuan as a international reserve currency.
From this perspective, the move to devalue the yuan simply represents a decision by the central bank to reverse a policy that had become too expensive in foreign exchange reserves and that was hurting the country’s economic growth rate by making China’s exports more expensive vis-à-vis competitors.
That’s one perspective.
For traders and investors, however, it’s not the most important perspective.
China’s devaluation of the yuan put downward pressure on the currencies of Asian trading partners that were already reeling. The very realistic fear, of course, was that these countries would seek to devalue their own currencies to maintain market share for their own exports. With China’s own economy slowing and thus reducing these country’s exports to China, they couldn’t afford to lose market share to cheaper Chinese goods in other markets.
And this is where memory comes in.
Some of these currencies are now at levels unseen in the last 17 tears.
Since the Asian currency crisis. Do you remember that crisis that started in July 1997? It cost Thai stocks 75% of their market value. The Indonesian economy lost 13.5% of GDP.
If you do remember, then the drop in the Indonesia rupiah and the Malaysian ringgit to seventeen-year lows on Wednesday conjures up some pretty scary scenarios.
No one projects an expect replay—foreign exchange reserves in developing economies are, far and away, larger than they were in 1997. Fewer emerging market currencies are pegged to the dollar. Interest rates are lower.
But the memory is the context for the current debate: Is the devaluation of the Chines yuan a one-off event or is it the first step in a round of competitive devaluations that will raise the dangers of corporate debt denominated in dollars becoming an unsustainable burden for some big companies somewhere and that will push the weakest emerging market economies toward crisis—if they are not there already. The list of the usual suspects includes Turkey and Brazil where current account deficits seem dangerously large and headed in the wrong direction. (Local politics in those two countries also make it tougher to get cash inflows from overseas investors.
A key determinant in how widespread the fallout from this crisis will stretch is how much further China’s yuan devaluation will go. Yuan bears are looking for another drop of 2% to 2.5% or so by the end of the year that would take the total drop in the value of the yuan to 5% or so.
That would certainly be enough to disrupt not just currency markets but economies and economic sectors.
My personal take is that with China’s economy showing signs of slowing further, we haven’t seen the last of devaluations from the People’s Bank—after we get a round of competitive devaluations from most of China’s biggest trading partners. (And don’t leave the EuroZone off that list)
Gold and energy commodities are up today. So are safe haven currencies such as the yen.
The Russian ruble is down. So is the euro and emerging market currencies and markets are taking a licking.
Pretty much what you’d expect when the crisis in the Ukraine has escalated to include a threat of armed conflict between Russian and Ukrainian soldiers
The biggest move has been in the share prices of energy companies that might benefit if natural gas prices soar due to a cut-off in gas exports from Russia across the Ukraine and into Western Europe.
For example, shares of Norwegian oil and gas producer Statoil (STO) are up 2.35% today as of 2 p.m. New York time.
Shares of energy companies without any near-term way to take advantage of any stoppage were off with Chesapeake Energy (CHK) down 1.2% and France’s Total (TOT) off 2.31%.
The oil benchmark price of the West Texas Intermediate climbed 1.77%. The Brent benchmark rose 1.6%.
Most of the moves I’m seeing today aren’t specific to the crisis but are instead the standard response of traders to heightened risk. For example, the safe haven yen rose to 101.4 to the U.S. dollar. The euro is off 0.43% against the dollar. Gold is up 2.15%. The iShares MSCI Emerging Markets ETF (EEM) is down 1.89%.
The ruble is the big crisis specific loser, down 1.4% today against a basket of currencies—despite an increase in benchmark interest rates from the Russian central bank. That continues the Russian currency’s slide in 2014. The ruble is now down more than 10% for 2014
The slow response of U.S. and EuroZone diplomats to the crisis with lots of talking and not much action (not necessarily a bad thing if the alternative is shoot first and talk later) suggests that this crisis will drag on for a while. An “emergency” meeting of EuroZone leaders isn’t scheduled to take place until Thursday, March 6.