The Fear Of Fears

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Includes: DIA, QQQ, SPY, VXX
by: Shareholders Unite

Summary

The year started with an unprecedented selloff in the financial markets.

Plenty of reasons have been offered for this, from oil, to China, to global recession fears, to a Fed prematurely tightening, expensive valuations, etc.

There is something to be said for many of these, but we think behind this lies a much bigger fear.

This is the fear that we've been able only to postpone the wave of deflation, possibly leading to debt-deflationary cycle but that we're now standing defenseless.

Plenty of reasons seem to have been given for the recent selloff on financial markets, but behind these lies a bigger fear. Let's start with some of the reasons that have been mentioned.

Oil

At first sight, it is sort of strange that the crash in the price of oil seems to produce such panic on the financial markets. It used to be the case that those benefiting from lower oil prices had higher propensities to consume compared to those that lost out.

However, this no longer seems the case. Or perhaps, as Krugman suggested, oil has become non-linear and large falls in the price of oil as we experience today are contractionary, not expansionary.

The financial distress at companies, financial institutions dealing with energy related debt, and whole countries combined could very well overwhelm the positives on energy consumers.

The fall of the price of oil (and those of other commodities) itself might also be conceived as a warning signal that the world economy is slowing down significantly.

What is rather notable is the correlation between US stock market and oil:

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And the correlation between oil movement and Chinese stocks is even more marked:

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One could argue that oil is the canary in the coalmine for China, although it's just as much a supply problem as it is a demand problem, which is what makes the correlation with stocks a bit of a conundrum.

But other commodities have sold off sharply as well, so one could still argue that these are signs of a significant slowdown in growth, which is of course difficult to deny anyway considering what's going on in manufacturing and emerging markets.

China

One of the biggest growth fears comes from China. Especially as the economic slowdown leads to capital outflows and substantial downward pressure on the yuan.

The slowdown as such isn't all that worrying as China isn't that much of an important export market, especially for the US (from Real-time economic issues watch):

Trade channels are limited (US exports to China represent less than 2 percent of GDP), and so are financial linkages. The main effect of a slowdown in China would be through lower commodity prices, which should help rather than hurt the United States.

Also (from Business Insider):

China accounts for less than 2% of total US foreign direct investment stock - at around $66 billion in 2014. By comparison, the US' investment position is $77 billion in France, $115 billion in Germany, and $311 billion in Ireland.

But a Chinese devaluation would be serious as it spreads a wave of deflation through the world economy. How likely is that? Well (Business Insider):

According to a report from the Institute of International Finance, $676 billion left China in 2015. It's a huge number. To put it in perspective, all emerging-market economies together saw outflows of $111 billion in 2014.

Other estimates put that even significantly higher, here is Bloomberg:

China's capital outflows jumped in December, with the estimated 2015 total reaching $1 trillion, underscoring the scale of the battle facing policy makers trying to hold up the yuan amid slower economic growth and slumping stocks. Outflows increased to $158.7 billion in December, the second-highest monthly outflow of the year after September's $194.3 billion, according to estimates compiled by Bloomberg Intelligence.

The PBOC, the Chinese central bank is struggling to fight further depreciation, and is spending inordinate amounts of forex reserves to keep the yuan up.

But given the decline of those forex reserves, from $4 trillion to $3.3 trillion in less than a year, even the PBOC can be overwhelmed at some stage. Policy choices are also rather awkward:

  • Forex intervention means automatic tightening within China, reinforcing the economic slowdown.
  • Further monetary easing would lead to additional capital outflow.
  • Trying depreciation stealthily in little steps can easily trigger further expectations and accelerate capital outflow, as we have seen last September.

In fact, China is running against the famous Trinity, which argues that no country can have independent monetary policy, a fixed exchange rate and free capital flows.

One way to get out of this Trilemma is to reinstate capital controls (many of which are still in place but these are obviously rather permeable). This would be a loss of face when China has been gradually liberalizing controls in order to boost the reserve status of the yuan.

Expect extreme volatility here with every morsel of new data pointing one way or another.

Receding dollars

Capital is flowing out of China and other emerging markets, forcing central banks from Beijing to Brasilia to sell dollar holdings, explaining part of the decline in yields.

But many OPEC countries are also forced to tap into their kitties, reversing the flow of petrodollars which is part of the global equity selloff and monetary contraction:

Growth scare

The fear is that with many emerging markets and oil producing countries already in slowdown or outright recession, some of which deep (Venezuela, Nigeria, Russia) and others like China slowing down, the rest of the world is running the risk of a marked slowdown or even recession.

Add to this the deflationary effect of the financial market rout itself, and the odds increase. Although there are few signs of a market general slowdown in activity in the advanced nations, it could very well be that financial markets know something that forecasters like the IMF don't.

On the other hand, stock market corrections have predicted 8 out of the last 5 recessions..

The truth is that while there is a slowdown in China and many emerging markets are in serious trouble, the US, Europe and Japan are still holding up, at least for now.

Yes, US manufacturing is weakening, but the PMI rebounded in January to 52.7 from a 38 month low in December (51.2), but even the latter still signaled expansion rather than contraction.

Like with China, expect volatility with every new data morsel pointing one way or another.

Earnings recession

What is fairly certain though is that corporate earnings are declining, we're experiencing an earnings recession. Much of this is due to falling commodities and especially oil, as these have a devastating effect on the bottom line of miners and oil companies.

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But it is also the quality of earnings that leaves much to be desired. Ever more companies report non-GAAP earnings, and are relying on buybacks to boost EPS.

Buyback nation

Here is FT Alphaville:

Share buybacks in the US are on pace for their biggest year since 2007, he adds, estimating $561bn for full-year 2015 (net of share issuance) and a decline to $400bn in full-year 2016. Aside from shares repurchases already scheduled under 10b5-1 plans, the markets will have to wait until February for the buyback taps to start flowing again properly.

All very well, but the problem is that buybacks are precluded in the month before earnings are released, which is one reason why the market has been so volatile until now. Many companies are simply precluded from buying back their shares.

Tightening Fed

Fed easing has come to a halt and has gotten into reverse, at least a little with the interest rate rise in December. Although one could argue monetary policy is still very accommodating, it's the prospects of further rate rises that has spooked the market, here is Richard Koo:

An increasingly messy divorce between market participants and monetary policymakers might be responsible for the market turmoil in 2016, according to Richard Koo. The "January correction was driven by realization that rate hikes could come faster than expected," he claims.

After the Fed statement on January 27, the markets sold off as the Fed wasn't recoiling sufficiently from their planned rate hike path, but can one imagine they are really going to raise rates in March?

Given the bad data out of US manufacturing, the dollar strength, the turmoil in the world economy and the absence of inflation, that doesn't seem likely to us.

But they kept their hands free, and if labor market data keeps on being strong, especially if there is a hint of wage growth, that might change. An oil price revival could also predispose the Fed back towards further rate hikes.

Overvaluation

After a near uninterrupted bull-run from the lows of March 2009, stocks got expensive for some time already. Combined with the earnings recession, a tightening Fed, an economic slowdown and worries about the quality of earnings, it is no wonder that shares sold off.

It is one thing for shares to sell off, the speed and violence this happened is quite another thing. Overvaluation alone cannot explain that, but it is certainly not helping as stocks are still far from cheap.

Index ETFs

Part of the overvaluation can be explained by the rise in index ETFs, here is CNBC:

Meanwhile, the price of the underlying equities in index funds is rising, though no one is sure exactly why. Research by S&P Capital IQ, as of Dec. 31, found stocks that were in the Russell 2000 were trading at a 50 percent premium to stocks that were not, up from 12 percent in 2006. The statistics are based on median price-to-book ratio.

While we didn't put it that way, we were aware that many stocks are already in bear territory and it looks like being part of an index that is popular in the ETF world is at least part of the explanation.

Fisherian debt deflationary cycle, the fear of fears

Stocks were, and still are expensive and earnings are declining a bit, but that should not really give rise to such a violent selloff.

The oil price crash could very well be a warning about a coming world recession, the fact that it is at least in part a supply problem, as well as the fact that lower oil prices are a boost to many economies makes the selloff somewhat puzzling.

China is a more serious problem, the slowdown and especially the large capital outflows pose a serious risk for a more substantial Chinese devaluation. However China also runs a substantial trade surplus, so on balance there doesn't seem to be a need for a drastic devaluation.

But the China and the oil/commodities fear tap into a bigger theme, it's the wave of deflation, combined with the inordinate amount of debt outstanding and the fear that central banks have no ammo left in the chamber that is causing the panic in the markets.

It's the fear that the reckoning of the excesses that led to the financial crisis in 2008 have been only postponed, rather than dealt with by central banks and the fear there is nothing to replace them, from The Telegraph:

The global financial system has become dangerously unstable and faces an avalanche of bankruptcies that will test social and political stability, a leading monetary theorist has warned. "The situation is worse than it was in 2007. Our macroeconomic ammunition to fight downturns is essentially all used up," said William White, the Swiss-based chairman of the OECD's review committee and former chief economist of the Bank for International Settlements (NASDAQ:BIS).

Indeed, that fear ran home on January the 28th when consumer prices declined by 0.9% in Germany, despite nearly a year of ECB pumping the prime.

Deflation combined with slow (let alone negative) growth and large outstanding debts are slow grinders at the best of times, but they feed on themselves and can easily become non-linear when a wave of defaults start to topple banks.

We're not there yet, but it is worrying to us that central banks haven't been able to create some moderate inflation which would greatly reduce these risks, and we're equally worried the Fed now seems to think that inflation is a substantial risk.

Markets, in the meantime, will go over every morsel of data and react with outsized movements, we think it's best to have a substantial amount of cash and only nibble at quality assets that have already gone through the wringer.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.