The stock market has had its worst start to a new year ever. Yes, ever. And it’s not just stocks feeling the pain, it’s commodities, bonds and currencies, too. But what has investors so rattled? Why the sell off? Investors are concerned about overall global growth. And here’s a few factors at the root of their worries.
China’s stock market is officially in bear market territory, meaning they are more than 20% off their highs. But this isn’t the first time. As a matter of fact, this is the second time in just the last 7 months that China’s market has entered bear market territory. This is a problem for the U.S. because China adds great spending power to the global economy. If China, the second largest economy in the world, starts spending less money, global growth tightens.
Adding fuel to the fire is the fact that China is a huge buyer of treasuries and the single largest holder of U.S. debt; they are a driving force for many global currencies. Uncertainty surrounding China brings a certain uneasiness to global markets. But the story gets even worse.
Investors are in the dark about the exact state of the Chinese economy. Because the country has certain governmental controls in place, investors cannot get a clear idea of just how strong or weak the economy really is. This uncertainty adds to the volatility. The concern is that policy makers are struggling to pump life back into the export dependent economy. And a weaker yuan only adds to investors’ worries that China’s troubles are greater than they appear.
The government put a growth target of 7% for 2016 and analysts just don’t see that happening.
The price of crude oil has fallen more than 70% since 2014 and the reason is simple. Supply and demand. When oil was expensive hovering around $100 a barrel, the U.S. was forced to implement new drill programs like horizontal drilling and hydraulic fracking. This led to a surge in U.S. oil production. In fact, last year the U.S. surpassed Saudi Arabia and Russia to become the world’s largest oil producer.
Usually, OPEC would cut back production to boost prices, but with the U.S. gaining ground, they decided to actually increase production to maintain market share. This resulted in an over supply of oil causing a drop in prices. Demand also slowed out of China as their economy slowed adding to the price drop. And a rebound doesn’t seem likely in the near future as Iran may be increasing its oil output soon. Nuclear sanctions being lifted on the country will allow Iran to export oil freely for the first time since 2012. Again, adding to supply.
But why would cheap oil put pressure on the markets? If cheaper oil means cheaper gasoline, shouldn’t that leave consumers with more cash to spend boosting the overall economy? Not necessarily.
A fall in oil prices hurts all risky asset prices because stocks and oil are directly correlated in the eyes of the market. Lower oil prices also means less capital spending. The decline in energy-related investments has had more of a negative affect on the economy than the consumer savings from cheap gasoline at the pump has been positive.
And its not just the energy sector. Other sectors like materials and industrials are hurt by oil being “too cheap.” The negative impact seen in these sectors is simply outweighing the positive results being seen in sectors like consumer discretionary. If consumers are saving money on gas, they have more cash to spend on discretionary items. But that lift isn’t enough to hold the pieces together in the other suffering sectors.
It is a growing consensus that the fall in oil prices has done more to stunt growth than boost it.
On December 16th, the Federal Reserve raised interest rates for the first time since 2006. Fed Chairman Janet Yellen also hinted toward four additional raises throughout 2016. This ended the period of record-low interest rates that were implemented to spark the U.S. economy after the financial crisis and recession.
But investors aren’t convinced the economy is healthy enough to support continued rate hikes. Yellen said she will rely strictly on economic data when making rate decisions going forward but the markets don’t seem to be buying it, literally. Although some data has been positive like the unemployment rate, other data such as retail sales and low inflation is giving mixed signals about the economy’s overall health.
The U.S. Dollar
Rate hikes mean a stronger dollar. Isn’t that a good thing for the stock market? Actually, no it’s not. Over 30% of the revenue generated by the companies in the S&P500 come from outside the United States. A strengthening dollar negatively impacts earnings for companies generating a large bulk of their revenue from other countries because their currency is worth less compared to the dollar. The manufacturing sector has suffered probably the biggest blow because of a strengthening dollar.
The Institute for Supply Management said its manufacturing index dropped to 48.2, the lowest mark since the last month of the Great Recession. Anything below 50 means there are more U.S. companies shrinking than there are growing.
In this case, it’s all about junk bonds. The junk bond market is comprised of riskier companies with large amounts of debt. This market has come under pressure as oil prices fall for fears that energy related companies will default on their debt. These worries have investors questioning how debt defaults in the energy market will affect the broader markets.