Stocks sold off today putting a cap on what has been an ugly first two weeks of 2016 for global financial markets. Let's take a look at what has driven the markets lower:
1) Oil- Crude prices fell to a twelve-year low of $29 a barrel. This is a decline of over 20% in January alone. There is no question that excess supply has been a significant factor in the decline in oil prices over the past eighteen months, but there still are very few signs that supply has been reduced in a meaningful way anywhere around the globe. Also, there continues to be no increase in demand and that is not good news for the global economy that already has it's hands full with adjusting to a slowing Chinese economy. Which takes us to point #2.
2) China- Last August China took financial markets by surprise when they devalued their currency, leading to stock market declines of more than 10% in many regions. After that decision authorities in China made a point to say there would be no reason for further devaluation. Fast forward to the first week in January and the People's Bank of China again devalued their currency, the yuan. This action has investors around the globe asking the question, is Chinese economic growth much weaker than Chinese authorities have acknowledged? The Chinese have projected 7% GDP growth for 2016. However some economists feel that growth will fall well short of 7% and that authorities in China will continue to devalue their currency to try and spur exports and increase growth.
So why would this cause so much pain for stocks in the U.S.? For the past four - five years the fast pace of economic growth in China has really helped the global economy overcome weak growth in Japan, Europe, Latin America, etc. If, and at this point it is still an if, China is dramatically slowing that will have a negative impact on the global economy and many U.S. companies. Also, as a result of the devaluation Chinese goods will become cheaper for U.S. importers. But when combined with plummeting commodity and oil prices, this will put significant deflationary pressures on the U.S. economy, which is a challenge our sluggish economy does not need.
On a side note, the Chinese stock market, The Shanghai Composite, is down over 18% so far in January. As we have said before action here should not be overplayed as the market does not have the same connection to the Chinese economy as Western markets have to their economies.
3) U.S. Retail Sales- The Commerce Department reported that Retail Sales grew just 2.1% in 2015, down from 3.9% in 2014 and from an average of 5.1% from 2010 - 2014. Even though the U.S. economy has seen average GDP growth of only 2% during this recovery, the U.S. consumer has been the bright spot up until now. The question is will this prove to be a temporary blip or is this the start of a slowdown? When taking a deeper look at the report there are pockets of strength and this is just one of many snapshots of the U.S. economy.
4) Federal Reserve- The Federal Reserve raised interest rates by .25% in December, ending the unprecedented run of seven years of 0%. While a .25% increase is a very small number, it isn't the size of the increase that has had an impact on the markets it is the psychology. Financial markets are now adjusting to the fact that after seven years of 0% interest rates and $4 trillion added to the Fed's balance sheet, the Fed is now in a tightening cycle. There is no way to measure how much impact the Fed rate increase has had on the volatility of the past few weeks but it is healthy for markets to adjust to higher interest rates.
We entered the year with a cautious stance and nothing has changed our position. The Federal Reserve projected four interest rate increases this year and we believed we would see no more than two. A March increase is probably off the table due to the current state of markets and especially the deflationary pressures that are increasing. We are entering the heart of earnings season and this will give us a very good look at not only the current state of the U.S. economy but also the impact the Chinese economic slowdown is having on U.S. companies. Stay tuned.