My base case is that the US stock market correction will not extend to major losses without a U.S.-based economic slowdown. Therefore, as potent as the Chinese devaluation crisis is as a signal for increasing global deflationary pressures, the U.S. should weather this episode until its vulnerable areas like shale oil run into trouble. Earnings growth vulnerability is a downside risk. In the meantime, emerging markets will continue to be impacted negatively via trade flows and commodity prices.
First, on U.S. markets, I used to be in the camp that says cyclical bear markets are coincident with economic slumps. And using this thinking, the latest bullish GDP and jobless claims data out of the U.S. would mean markets, while overvalued, can find footing and even continue higher. But when I look at the actual data, this doesn’t hold up.
For example, in 1966 the Dow Jones Industrial Average opened the year at 969 and dropped to below 800 by year-end. Now, the market did rally again to a new high at 985 in November 1968 before declining into the 1970 recession. But irrespective of whether one uses January 1966 or November 1968 as the beginning of that cyclical (and secular) bear market, the market high was well before recession in January 1970.
Then, if you look at the market high in December 1972, that was well before recession officially began in December 1973, during a period when real GDP growth was accelerating, though it peaked in Q1 1973. And again, we saw an intermediate high on the Dow above 1000 in December 1976, yet recession began in February 1980, over three years later.
So, the concept that markets rally into near the trough of the economic cycle just doesn’t hold water. Nevertheless, my base case is for U.S. markets to hold. However, we should be aware of the fact that markets turn over before the economic cycle turns down as earnings growth weakens in the period leading into an economic trough. As a result, we don’t need to see poor economic data for the U.S. equity market to weaken, given its elevated levels compared to most cross-cycle valuation metrics.
In terms of the real economy in the U.S, despite the 3.7% real GDP growth number for Q2, I would like to see wage growth as a marker of sustainable earnings growth and this simply isn’t happening. Moreover, the operating margins in US companies are mean-reverting. Stock buybacks will only be able to hold up these markets for so long. Finally, let’s also remember that the S&P500 is more leveraged to what happens abroad than ever before given the percentage of earnings that comes from overseas. So the global growth slowdown will negatively impact earnings regardless of what happens in the U.S.
In sum, while I am generally sanguine about the U.S. economy, I am now on alert about U.S. equity markets because I believe the China devaluation crisis is a meaningful marker in the slowdown in global growth. And given the lack of U.S. wage growth, I don’t see a sustainable underpinning for much more earnings growth in this cycle.
When we look at what is happening with China, one way to think about it is as being inherently a problem of overcapacity due to malinvestment, meaning the deflationary pressures in China are supply driven rather than demand-driven. No manner of stimulus will boost domestic demand enough to meet the excess capacity and so China will slow. The question is how it slows, how fast it slows and what policies are put in place to ameliorate that slowing. For example, if China tries to pull the interest rate lever by lowering interest rates to ease domestic credit conditions as a primary vehicle for easing, it is simply making it easier to sustain overcapacity. It would be giving a lifeline to companies that are contributing to global manufacturing overcapacity. And, in an environment of domestic producer price deflation in excess of 5%, this is deflationary, not inflationary.
What the Chinese need to do to combat the slowing growth – and what will eventually happen – is allow the currency to act more as the release valve. I think 10% down is very doable by year-end. And of course, this will export China’s deflation abroad, exactly the reason that commodity markets and emerging markets are selling off. If China tries to hold the peg while lowering rates, it will continue the overcapacity problem, something that can only be alleviated via tightening domestic credit conditions associated with the currency intervention to hold the peg. And this risks a hard landing. I believe this will also mean a continued skew toward the sectors suffering overcapacity. But let’s see how this unfolds.
For the time being, as the growth slowdown in China plays out, we should expect the pressure on commodity and oil prices to remain. And the impact will thus be greatest on emerging markets and developed markets most leveraged to oil and commodities like Canada, New Zealand and Australia. India is the emerging market that looks most likely to benefit given its oil importing role.
From a U.S. perspective, the biggest economic impact will be in shale oil and oil-related capital investment as reserve accounting takes its toll on balance sheets. I expect the market death scenario to begin to play out in the U.S. and for this to weaken U.S. growth by Q4.
In sum, right now the numbers look good, both on GDP and on jobs. But underneath, things are softer. The Fed could hike rates next month because of the 3.7% growth number, but right now there is no catalyst for an uptick in U.S. growth. I see this number as a one-off, with the U.S. continuing a middling path, the greatest risk being to the downside.