The Fed’s Two-Day Correction

There were ostensibly three factors behind the recent stock market correction: (1) fear of a slow down in China, which can’t be stopped regardless of measures out of Beijing; (2) a sell off in commodities, which is pressuring emerging markets; and (3) continued concern about when the Federal Reserve will increase interest rates and how the lift off will impact asset prices. After two weeks of volatility, I am more convinced that the Fed may have had a larger role in the correction than the other two factors. Many look back to last Monday (aka “Black Monday” in China, where the main stock market index plunged 8.5 percent) as the beginning of the brutal downside action. Despite reports that Chinese government intervention was coming; there was none that day. All of the sudden, there was talk about the spread of contagion from a collapse in the Chinese stock market, to the Chinese economy, to emerging market economies and then to developed economies.

Let’s peel back the onion on this theory. According to Capital Economics, “The debacle in China’s equity market tells us little directly about what is going on in China’s economy.” The reason is that the massive bull market bubble, which began in 2014 and peaked on June 12th, “was speculative, rather than driven by any improvement in fundamentals…we are witnessing the inevitable implosion of an equity market bubble.” Since the top, the bears have wiped out $4.5 trillion of Chinese stock market value. Despite the massacre, the Shanghai Index is up 1.4 percent this year and a staggering 48 percent from a year ago.

Fear of a hard economic landing in China has been floating around for some time. In the big picture, the days of China’s double-digit growth rates are behind it. But because the total Chinese economy has increased in size, it continues to contribute more than a third of global growth. That’s why a slow down in growth from the government’s 7 percent target, to something closer to 5 percent this year, will reduce Chinese demand for a host of commodities, hence the rout in oil, industrial metals and emerging market trading partners who export those items to China.

And for those who were banking on the Chinese government to shield them from the effects of a slowdown, one hedge fund manager told me, “Too many investors believe that officials in Beijing know what they are doing. In fact, China is really in the minor league when it comes to economic management. Think of the U.S. as any big major league franchise, like the Yankees, the Giants or the Cardinals…China is like the Toledo Mud Hens-lots of great potential, but not in the show just yet.”

Of course all policy makers make mistakes (see: ECB), so maybe the take away is that when central bankers get nervous, we should all get nervous. And that leads us to what could have been the most important factor in the recent sell-off: the U.S. Federal Reserve. Yes, the impact of China and falling commodities is important, but some believe that that the selling pressure began on the Wednesday before Black Monday. That’s when minutes from the last Federal Reserve meeting were released. The officials’ views on current conditions painted a picture not of an economy rebounding strongly after a tough, weather-related first quarter, but of one that still faces downside risk, including “persistent weakness in the housing sector”. That comment prompted a lot of chatter because the data seem to indicate that housing is gaining a lot of momentum.

All of the sudden, it appeared that the Fed was not entirely sure what was going on and how it would respond to global events – that uncertainty sent shivers across trading floors. The stock drop only ceased after New York Federal Reserve President Bill Dudley, said that turbulence in the financial markets made a September rate hike “less compelling” than it was a few weeks ago.

With an economy growing at a better than three percent annualized pace, a labor market creating more than 200,000 positions per month, consumers and businesses spending more freely and a housing market finally making inroads, the best justification the central bank has for keeping rates at emergency levels is that there is little evidence of inflation. Still, it is hard to justify treating the U.S. economy like it is still in the intensive care unit. At some point, the central bank is going to have to normalize policy and when it does, nobody really knows how financial markets will react.

MARKETS: With one trading day left in August, stocks are on track for their worst monthly performance in three years.

• DJIA: 16,643 up 1.1% on week, down 6.6% YTD
• S&P 500: 1,988 up 0.9% on week, down 3.4% YTD
• NASDAQ: 4,828 up 2.6% on week, up 1.9 YTD
• Russell 2000: 1163, up 0.5% on week, down 3.5% YTD
• 10-Year Treasury yield: 2.19% (from 2.05% a week ago)
• October Crude: $45.22, up 11.8% on week
• December Gold: $1,134, down 2.2% on week
• AAA Nat'l avg. for gallon of reg. gas: $2.49 (from $2.61 wk ago, $3.44 a year ago)

THE WEEK AHEAD: It will be a busy, pre-holiday week on the economic calendar, highlighted by the August employment report. It is expected that the economy created 225,000 jobs and the unemployment rate should edge down to 5.2 percent.

Mon 8/31:

9:45 Chicago PMI

10:30 Dallas Fed Mfg Survey

Tues 9/1:

Motor Vehicle Sales

9:45 PMI Manufacturing Index

10:00 ISM Mfg Index

10:00 Construction Spending

Weds 9/2:

8:15 ADP Employment Report

8:30 Productivity and Costs

10:00 Factory Orders

2:00 Fed Beige Book

Thurs 9/3: 9:45 PMI Services Index

10:00 ISM Non-Mfg Index

Fri 9/4:

8:30 August Jobs Report

Correction Reflection

Time flies when investors are enjoying a bull market. It has been four, mostly blissful years since the last 10 percent correction for stock markets. Back then, the fragile economic recovery was at risk due to a Congressional battle over raising the US debt ceiling limit. This time around, we have plain old anxiety about global economic growth. Although the U.S. economy continues to show improvement, the fear is that a slowdown in the world’s second largest economy – China – not to mention the cooling of once-hot emerging economies like Brazil and Russia, will impact the rest of the world. Considering that Europe and Japan are muddling along and the U.S. is only growing by about 2.5 percent a year, any significant headwind could pose a threat.

Yes, you have heard this story before, but previously, when sluggishness infected China, the government there would waive its magic wand and poof—things would pick up. This time, efforts by Beijing officials to intervene in its stock and currency markets have thus far failed to quell the slowdown fears.

As a result of the China deceleration story, commodities have also came under renewed pressure. After bouncing up to $60 per barrel earlier this year, fear that Chinese demand would wane, as U.S. and OPEC’s production remains high, culminated in an 8-week rout that left NY oil futures at $40.45 per barrel, the lowest price since March 2009. Crude is now 34 percent off its 2015 peak and down a staggering 62 percent from a year ago.

The sell-off in oil has pushed down the big energy companies in the Dow and S&P 500, but that’s not the only industry under pressure. Apple stock is down by more than 20 percent from its May high; 328 stocks within the S&P 500 are in correction territory; and about a quarter of them are down more than 20 percent. So, even though the S&P 500 has not yet dropped by 10 percent from its recent peak, two-thirds of its components are suffering mightily.

​​OK, so now you know what’s behind the market drubbing, but it is important to note that corrections are a normal part of market action. According to Capital Research and Management, through last year, 10 percent corrections occur about every year, so we have been long overdue for one. (20 percent bear markets occur about every 3 ½ years, so we are also due for one of those—the last one ended in March 2009.)

If you forgot about the downside risk of owning stocks, shame on you—there’s no crying in baseball or investing! Over the last 15 years, markets have shown that wild swings are part of being in the game. Hopefully, most investors learned the beauty of a diversified portfolio, one that can help avoid a cycle of buying high/selling low. Additionally, one of the big lessons of the financial crisis/bear market/Great Recession is that everyone should strive to keep at least six months in an emergency reserve fund-twelve months is preferable. If a big expense is coming up, the money necessary to cover it should never be at risk in the stock market.

MARKETS:

• DJIA: 16,459 down 5.8% on week, down 7.7% YTD (down 10.1% from peak)
• S&P 500: 1,970 down 5.8% on week, down 4.3% YTD (down 7.5% from peak)
• NASDAQ: 4,706 down 6.8% on week, down 0.6% YTD (down 9.8% from peak)
• Russell 2000: 1156, down 4.6% on week, down 4% YTD (down 10.5% from peak)
• 10-Year Treasury yield: 2.05% (from 2.2% a week ago)
• October Crude: $40.45, down 6.2% on week
• October Gold: $1,159.60, up 4.2% on week
• AAA Nat'l avg. for gallon of reg. gas: $2.61 (from $2.67 wk ago, $3.44 a year ago)

THE WEEK AHEAD: The market noise has left many wondering if the Federal Reserve might delay its lift off for rate increases. Before the sell-off, consensus was forming around a quarter point bump at the September meeting, but there could be more clues about the Fed’s thinking at the Jackson Hole symposium economic issues facing the U.S. and world economies occurs. The annual event, sponsored by the Kansas City Fed, has often been a place where central bankers introduce new policies, but Janet Yellen has decided not to participate, the first Fed chair to skip the Western sojourn in some time.

Mon 8/24:

8:30 Chicago Fed National Activity Index

Tues 8/25:

9:00 S&P Case-Shiller Home Price Index

10:00 New Home Sales

10:00 Consumer Confidence

Weds 8/26:

8:30 Durable Goods Orders

Thurs 8/27:

Federal Reserve Jackson Hole Symposium begins

8:30 GDP (Q2 2nd reading, expected to be revised from +2.3% to +3.2%)

8:30 Corporate Profits

10:00 Pending Home Sales Index

11:00 Kansas City Fed Manufacturing Index

Fri 8/28:

Federal Reserve Jackson Hole Symposium

8:30 Personal Income and Outlays

10:00 Consumer Sentiment