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Outsiders Still Lurk for Stock Market: China, Oil, and Deflation

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February 11, 2016
Outsiders Still Lurk for Stock Market: China, Oil, and Deflation

China’s economic slump and the little traction from efforts there to pump liquidity into the banking system helped send U.S. stocks on their worst January skid ever. Oil’s price plunge to 12-year lows sure didn’t help, bruising energy shares and depressing commodities prices to the point of risking entrenched deflation for much of the world.

The rough start leaves traders and retirement-eve investors wondering how 2016 could pan out considering China's issues, oil, and global deflation are likely to stick around. Stock market volatility, as measured by the CBOE’s Volatility Index (VIX), is trending higher in 2016 than the average going back to at least 2011.

With this backdrop, discipline may be the required investing strategy for 2016 as traders sort out what could be next. “Consider keeping your position sizes smaller than normal when volatility increases and wide out your stops and sell/buy prices as well," says JJ Kinahan, chief market strategist, at TD Ameritrade.

Many industry analysts scratched out their forecasts as much has changed in a few short weeks. This year was once assumed to usher in higher U.S. interest rates. Now, financial market participants aren’t so sure.

Heading into 2016 there were forecasts for as much as four quarter-point rate hikes this year. The CME Group’s FedWatch tool, which crunches policy change probabilities priced into short-term interest rate futures, shows only a 26% chance for a summer or autumn rate hike at this point.

Fed odds have been recalculated and so have market projections. Count UBS among the latest banks to rethink some numbers. Equity strategist Julian Emanuel revised his 2016 S&P 500 (SPX), in figure 1, year-end target down to 2,175 from 2,275. 

S&P 500 drops in 2016

FIGURE 1: NOW WHAT?

The S&P 500 (SPX), plotted here through early February on TD Ameritrade’s thinkorswim® platform, shed some 15% from its all-time high of 2,134 scored in May 2015 to its lowest point to date in 2016, at 1,812. It did recover some 100 points from that low in early February with much of its movement closely tracking energy sector swings. Data source: Standard & Poor’s. For illustrative purposes only. Past performance does not guarantee future results.

Right now, it’s a push-pull between bearish and bullish factors. That’s true in most market conditions, but the conflicting sentiment is particularly noteworthy just now.

Bearish Jitters

For starters, who knows by how much China’s growth could slow? Some analysts estimate that China’s troubled credit could exceed $5 trillion, a staggering number that is equivalent to half the size of the country’s annual economic output. As soon as late 2016, some 22% of China’s loans could be non-performing, The New York Times reports. Official figures show that Chinese banks pulled back on their lending in December, although early January stock depreciation did bring about short-term liquidity efforts for its banking system.

As stocks waver, global demand is flowing back into the U.S. Treasury market. That, of course, lifts bond prices and pushes down yields, meaning that market interest rates are falling at a time when the Federal Reserve had penciled in a go-slow series of rate hikes meant to unwind unprecedented easy monetary policy.

The market is depressing rates (good for home buyers), but this move could leave the Fed itself a little depressed. If the U.S. central bank abandons a modest rate-hike campaign it potentially risks inciting panic. The investing and consuming public could assume that ugly global conditions have leeched onto the U.S. economy and the stock market. But raise rates in this deflationary environment (the Fed might point to improving job market conditions) and Janet Yellen and crew risk fueling global risks that may penetrate Wall Street’s gates.

Did the Fed make a December rate-hike mistake that only adds to market confusion? Maybe. But there’s nothing preventing the Fed from slowing its policy plans and its clever rhetoric has left the door open to this possibility. Does it complicate policy down the road? Potentially.

Bullish(ish) Case

Is there one? Yes.

Some industry economists note that an external shock such as deflationary commodity prices or a deeper Chinese slowdown could be less severe for the U.S. stock market than a homegrown problem, the 2007-2008 housing market collapse, for instance. It’s true that China’s cough can make the rest of the world ill. U.S. exporters will feel it. But a deflationary situation is tougher on producers initially than on consumers as oil and food costs are contained. Lost housing equity on the other hand? That hits consumers where it counts.

Economists point to the 1998 Asian financial crisis. It smacked the stock market pretty good for a time, but overall the economic fallout for the U.S. was contained. Optimists argue that the same may hold true for this China-led “crisis.” Will emerging markets that are big Chinese trading partners get hit? Yes. Are commodities-sensitive economies struggling? Yes. Should traders and investors beware? Yes. But is the foundation of the U.S. stock market able to withstand these outside forces? Time will tell. But the supportive structure is in place.

Plus, the world is responding to China, which may do some de facto work for the Fed.

“Europe remains squarely in a monetary easing cycle, which is jump starting the region’s credit growth and overall business cycles. This environment created a tailwind for Europe’s equity markets in 2015 and is expected to continue to help the region’s stocks in 2016,” says Heidi Richardson, head of U.S. investment strategy for BlackRock’s iShares.

She continues: “The Japanese market is a similar story. Stocks in Japan benefited last year from continued easy money from the Bank of Japan and I see sustained monetary policy easing continuing to support the market going forward in 2016.”

Competition for U.S. stocks from these corners of the world? Potentially. But more likely the potential for short-term global market stability that could let U.S. investors focus more on earnings results. That will take a tactical sector-by-sector or name-by-name approach to the stock market. Remember, much of the drag on earnings forecasts comes from weak oil prices and a strong dollar. It could prove important to assess the health of the broader economy outside of these—yes, still important—factors.

As for earnings, UBS’ Emanuel cut his S&P 500 earnings-per-share target to $119 from $126 for 2016, still implying a 1.4% increase from 2015.

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