While 2015 was the year of policy and market uncertainty, 2016 has begun with some very certain selling. US equity markets are off to their worst start of any year in history. If you own equities you have just lost money, and if you watch the financial press you have seen many reasons why. Let’s examine what is not happening, and then speculate about what may be happening.
We believe there are several issues making headlines as “causes” of January’s stock market selling that are not really to blame.
1. China. Chinese equity markets have suffered large losses since December 23, and revaluation of the Chinese yuan is getting most of the blame. The Chinese currency has fallen almost 8% against the US Dollar since last April, and many fear that China’s currency and stock market declines will spread to the US or even cause a recession here at home. Importantly, this is not a deliberate government attempt to devalue. Instead, it reflects capital flight from an economy still looking for a bottom. It also reflects the unwinding of a hugely overvalued speculative stock market. As Larry Kudlow points out,
“Actually, the Chinese are trying to stop the yuan from falling. Their FX reserves dropped $108 billion in December with overall reserves falling $418 billion. In all likelihood, the People’s Bank of China has been selling dollars to try to support the yuan. But it can’t beat the market, which is saying the yuan is overvalued for a weak economy. It’s just like the dollar: A rising dollar is a tightening, and a falling dollar is an easing. A falling yuan driven by market-oriented capital outflows would be a stimulative easing policy — if the authorities let it happen. Meanwhile, US exports to China, at $118 billion, make up two-thirds of 1% of US GDP. That’s miniscule. This idea of importing recession is gibberish. In fact, Chinese t-shirts and sneakers will be cheaper for American consumers as the dollar goes up and the yuan goes down. So there’s no recession coming from China.”
As Scott Grannis further explains,
“Markets are very powerful forces, and the Chinese economy and its markets are now so large that the government has essentially lost the ability to manage things according to bureaucrats’ whims. This is good news for the long haul, but expect to see further dislocations along the way, because bureaucrats are loathe to give up their power.”
So while China is “Learning a Costly Lesson,” their mistakes will not cause a crash in the US economy, US currency or US stock market.
The headlines may blame China for recent US equity selling, but we don’t agree.
2. 2008, Again. Not only do we not see Chinese weakness spreading to the US economy, we do not see any concrete evidence of looming recession. Swap spreads, which usually widen ahead of and during an economic slowdown, remain calm and are even near historic lows. Credit spreads have widened to 150 basis points, where they were in 2012 during the PIIGS European crisis. These spreads are up but far from panic levels reached in 2008-09 when they reached over 350 basis points. Both swap and credit spread markets show minimal systemic concern and certainly do not signal a financial market “black out” experienced when the banking system “froze” in 2008.
Another encouraging sign is the bond market continues to price in rising real growth rates, as the chart below from Laffer Associates shows. The real growth rate embedded in 10 year Treasury bond yields is unacceptably low at a mere 0.71%, but that rate has been rising from the 0% level for twelve months. Current real growth is also substantially higher than panic levels of 2012 when the bond market was pricing in real US growth of negative 1%.
3. Oil’s Crash. Commodity price declines should have been an expected byproduct of US Dollar strength over the past few years. We continue to believe that weak dollar helped assets like commodities, commodity linked sectors and commodity linked countries will suffer as long as the US Dollar remains strong. Assets exposed to these areas remain in red zones and should be avoided. In terms of weak commodity prices impacting the US economy, remember there has never been a recession caused by low oil prices despite what the Wall Street Journal reports, The Recession Caused by Low Oil Prices. Cause and effect are often mixed up, and this time is no different. If there is a recession in the US it will not be caused by the cost of what we buy going down. Here is the classical economic story in brief.
There are two effects: income effects and balance sheet effects. If all energy providers were foreign citizens or companies, the income effect here would be zero. When oil prices fall, oil sellers’ incomes go down but oil buyers’ incomes, in effect, go up by an equal amount. But all the oil sellers are not outside of the US. Some are here. So US oil sellers’ incomes do fall, but they fall by less than oil buyers’ incomes increase.
There are also incentive and balance sheet effects. Oil buyers will clearly consume more as oil prices fall and sellers will try to increase quantity sold further pushing prices to fall. Assets and liabilities will change producing shocks, windfall gains and windfall losses.
The headlines may blame crashing oil prices for recent US equity selling, but we don’t agree.
Overall, there are many reasons being given for the market decline to start 2016. As we outlined above, we do not believe this selloff is caused by China, a 2008 style panic or weak oil and commodity linked prices caused by a strong US Dollar. We do believe the period of price stability from 2015 has ended, and we have entered a period of heightened uncertainty about the policy shift coming in this year’s presidential election. It is unclear what the resultant policies will be from November’s election, but there definitely will be serious economic policy consequences. Continued policies of government economic repression will warrant a low economic growth rate, while even modest reform in taxation and regulation will produce an enormous increase in economic activity. This is nothing new for “Reading the World” readers, as we have been writing about policy uncertainty ahead of November 2016 since last summer.
But what happened in “policy land” over the past few weeks to cause such a sharp decline in US equity prices in such a short period. There was no major policy shift or legislation that happened between January 1 and now. In looking for what policy assessment we were missing that markets are clearly fearing, we uncovered what we think is the “smoking gun” to this recent terrible equity performance.
With few initially noticing and with a rapid pace, Democratic presidential nominee Hilary Clinton lost her commanding lead in the polls. Candidate Bernie Sanders now trails Clinton only 39 to 42 in a recent IBD national poll, and Sanders is actually now ahead of Clinton in today’s NBC poll for New Hampshire (Sanders leads 57-48.) There has been a huge and rapid polling shift away from Hilary Clinton and towards Bernie Sanders, and the pace has accelerated since January 1 when more details were revealed about Clinton’s email scandal. The National Review writes,
“There is vitriol of an intense amount developing in the intelligence community and that FBI agents are already in the process of gearing themselves to basically revolt if [the Justice Department] refuses to bring charges against either Hillary Clinton or her former State Department staffers. It was the State Department’s data dump in the wee hours of January 1 that revealed a particularly eyebrow-raising e-mail from Hillary Clinton.”
Equity markets were closed on January 1 when the data dump happened with the S&P 500 near the 2050 level where it had averaged for most of the prior two months. When the market opened on January 4 equities began a free fall and have traded down most days since.
Investors sold US equities because of the huge reset higher in policy uncertainty from the turmoil in Democratic nominees. There are two main policy risks that just increased. First, as Sanders steals Hilary’s support the odds of his policy agenda becoming reality increase. Sanders’ policy agenda is littered with anti-growth economic ideas. His war on inequality begins with huge marginal tax rate increases. Sanders has suggested that he would be open to a 90% top marginal tax rate (a rate that last existed during the years after World War II) for the wealthiest earners and has proposed a top marginal rate of 65% for the federal estate tax, up from the current 40% rate.
Second, if Hilary manages to hold onto the nomination and win the election then investors have more reason to fear her dishonesty as president. Trust is quickly broken and can only be repaired over time through actions not rhetoric. It will be even harder to trust what Hilary promises and the policy ideas she supports given this new round of scandal.
The good news is the presidential election is still nine months away, plenty of time for a different and more bullish policy narrative to develop. The bad news is while markets will not likely go down 5% each week until the election, there is now a new round of uncertainty involving the Democratic candidate. This did not exist until recently and could lead to higher market volatility both up and down until we get closer to the election and/or get more clarity about final candidates and their agendas. Now is not a time for panic selling, but it is time to adjust our policy expectations and remember that policy shifts are powerful forces on asset prices. A shift towards policy uncertainty is still shift even though no new laws are passed or offices changed. Investors in 2016 must become more political analysts than anything else.
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