As usual the market’s talking heads have been proven wrong. There was supposed to be a Santa Claus equity rally. In the words of one expert, a rip your face off rally was in the cards. I guess the market had a bigger wall of worry in mind to climb.
So what’s going on? We are in a period of readjustment. There are so many forces that can affect the economy and the markets that are out of whack, it’s hard to find a place to start. But let’s start with the obvious, quantitative easing, or QE for short.
The Fed has started to raise rates. Their stated intention is to raise another four times for a total of one percent over the remainder of 2016. All this does is remove monetary accommodation; it doesn’t tighten the screws. We have to get back to a period of normalcy and the Fed is taking the first steps. However, the markets don’t really know how to deal with this change. It’s been almost a decade since the Fed brought short-term rates to zero. Young financial advisors who are now managing money for clients have never had to deal with this type of environment. Markets now have to value companies in a scenario where the cost of money is getting more expensive and roll that into profit calculations.
The Fed has also stopped buying bonds in its QE program. This has removed a source of additional liquidity in the economy. As a whole, valuations for the equity markets most likely have to be brought lower as the sugar high is wearing off. The market is doing this all by itself.
The second issue many pundits have brought up is the situation in China. Rather than being a huge drag on the American economy, American exports to China are not an existential threat to our economy; the China problem is more one of uncertainty. Being the world’s second largest economy, or largest depending on the metric one uses, a slowdown in China injects a huge unknown into the markets. China could be the new black swan if things get much worse. At a minimum, the world can no longer trust the Communist Party’s management of their economy and markets. Their corruption and ‘managed capitalism’ have spooked the world. It will take some time, and some smart decisions, until this mistrust goes away.
The collapse in the price of crude oil has been the final straw. However, I take the market’s correlation to the price of oil more of an excuse than a hard and fast cause and effect. At some point, the equity market will decouple from the price of crude but only when we get to a point where valuations are rationalized. I think we are obviously closer to a bottom for oil than a top but we could easily drop to the mid teens before oil puts in a bottom. Barring some unforeseen upside catalyst, I would expect the market to use oil as a crutch to correct itself even further.
All in all, the equity correction is very healthy. At some point, the dollar will retreat and oil will start to climb, although crude could bounce along the bottom for quite some time. The bond market remains very expensive and a source of extreme danger. The world still has to work off boat loads of debt in the developed and emerging market economies. This will not be easy and is the biggest danger the global economy still faces. We are simply in a period of readjustment from free and easy money. These things tend to take a long time to play themselves out.
L. Todd Wood is a former emerging market debt trader with 18 years of Wall Street and international experience. He is also an author of historical fiction thriller novels. His first of several books, Currency, deals with the consequences of overwhelming sovereign debt. He is a contributor to many media outlets and is a foreign correspondent for Newsmax TV. LToddWood.com