There was no Santa Clause rally in 2015. In the last few months, the market has done poorly, with the S&P 500 falling 1.75% in December and another 4.9% in the first four trading days of 2016 - the worst start to a new year for the S&P 500. The labor market seems fine, and consumers seemed to have opened their wallets and purses for the holiday season (retail sales up 7%+, and auto sales at an all-time annual record). ADP says 257,000 jobs were created in December, and consumer confidence rose in December in both national surveys. So, what's eating at Wall Street?
There are several issues on traders' minds. Some pundits say that the labor market is not as strong as it seems, and because manufacturing in the U.S. is now contracting and the oil industry is clearly in disarray, a recession is imminent. Others are worried that China will have a hard landing, and some say the Fed was too accommodative for too long, causing the equity market to rise too rapidly. That's a lot to be worried about.
The Labor Market
I have written in many different venues that the data - from the number of job openings, to the inability of businesses to find qualified applicants, to 40-year lows in new unemployment claims - show that the labor market is tight. Yet, there has been a consistent drum beat from some with other agendas that there are so many workers who are so discouraged that they have dropped out of the labor force. They point to the 4-percentage point drop in the labor force participation rate (the number of people having or wanting a job divided by the total population), from 66.4% of the population in January '07 to 62.5% in November. But a closer look at the data indicates that the change in the labor force participation rate is entirely structural, and that the changes are entirely driven by demographics.
- Of the approximate 15.5 million "not in the labor force," about 10.5 million, or 68%, were aged 55+, and 93% of those aged 55+ and out of the labor force, or approximately 9.8 million, indicate that they "do not want a job now," which is government-speak for "retired."
- If we added this 9.8 million back to the labor force, the labor force participation rate would be 66.3%, right under the January '07 peak of 66.4%.
- The inescapable conclusion is that the change in the labor force participation rate is structural, is not indicative of a discouraged labor force, is due to retirees, and is consistent with a tight labor market.
Yet, despite the facts and the illogic of the conclusion that there is still significant slack in the labor force, Wall Street is worried about this.
There is no doubt that U.S. manufacturing is the victim of the mercantilist policies of most of the rest of the world. By that I mean, allowing the dollar to strengthen by an average of 15% versus the rest of the world puts U.S. manufacturing exporters at a huge disadvantage. The strong currency has a dual impact: 1) It reduces foreign demand for U.S.-produced goods; and, 2) It reduces domestic demand too, as foreign capital equipment is now cheaper. Thus, it is the U.S. manufacturing sector that has borne much of the burden of adjusting to a world manufacturing economy with excess capacity. What is stunning is that given the state of the oil industry and the strength of the dollar, it took until November 2015 for the industry to actually show an overall contraction (the ISM Manufacturing index was at 48.6 in November and at 48.2 in December, where 50 is the demarcation line between expansion and contraction). No wonder Wall Street is worried!
Ironically, for years, the U.S. has desired to be oil independent. And right at the point of such achievement, OPEC and the Saudis decide that an oil price war, to drive the marginal American oil producer out of business, was in their best interest. (The price war, by the way, is quite beneficial to the U.S. consumer.) More than 40 years have gone by since the first OPEC oil embargo, and several Middle Eastern countries (kingdoms) have accumulated untold wealth from western industrial nations. Now, they are trying to use that wealth to maintain their hegemony. From an economic viewpoint, however, their ploy will ultimately fail:
- Saudi Arabia currently is running an unsustainable 20% deficit/GDP ratio, which can't go on very long;
- Fracking technology will act to keep the price of oil relatively low over the long term, though there could be temporary short-term price spikes (war, embargos, political instability), because if higher oil prices appear to be permanent, then the higher cost oil from fracking can once again profitably enter the market.
On top of all of this, the Middle East has become a hotbed of instability, with ISIS now in Libya, Yemen, Syria, and Iraq. And now, North Korea claims to have a hydrogen bomb. No wonder Wall Street is worried!
Finally, the oil industry in the U.S. is currently in disarray. Places like North Dakota and Alaska, which just two years ago were in unprecedented oil booms, now find their economies in recession or worse. Alaska, which received much of its public funding from oil taxation, is now considering an income tax (good luck with that!). Texas, whose economy is broadly diversified, is also feeling the fallout of failing marginal oil producers. All of this has recently hit the junk bond market, which, in November and December, saw record-setting selling despite the fact that only a very small portion of that market (15%) is oil-related. The danger here is that market panic in junk bonds can morph into something more sinister and move to other market segments. No wonder Wall Street is worried!
Most of the worldwide slowdown in 2015 was caused by China's manufacturing economy. Truth be told, the massive infrastructure building there after the recession was a bubble. There were reports of empty cities as far back as 2012. That, of course, is what happens in a centrally planned economy (the central government tells the captive political units to produce more GDP, and they respond by building unneeded buildings). Now that China is switching to a more capitalistic, consumer-led economy, there is much less demand for raw materials and heavy manufactured products that are part and parcel of infrastructure projects. Wall Street continues to worry about a hard landing in China! The question is: Is a 6% rate of growth a hard landing?
Wall Street is also worried about volatility in China's equity markets, as the two major exchanges there were in meltdown mode in the first week of January. The issue appears to be that large holders of individual securities have been prohibited from selling since the August meltdown, and that prohibition was to have ended on Friday, January 8 (that has been deferred to an unknown date). Naturally, all of the small fry want out before large holders can trigger sell orders. The Chinese instituted circuit breakers on January 4, where the markets close when they fall 7%. On Wednesday, January 6, after the market closed for the day after one hour of trading, they abandoned the circuit breakers. So, once again, it is government policy that appears to be the cause of the volatility - just the opposite of the policy's intent. Fortunately, in China today, there is very little correlation between the real economy and their equities markets, as the vast majority of Chinese are not playing in the market and don't have their economic well-being attached to it.
But a real worry is, now that China's currency is part of the IMF's currency basket (i.e., the "Special Drawing Rights", which are used to aid economies in crisis), a long-sought Chinese goal, they will become "mercantilistic" and depreciate their currency for their own advantage. This appears to be happening as we enter 2016. Unless there is a U.S. policy response (doubtful), the dollar will strengthen against the Chinese yuan, causing more pain in the U.S. manufacturing sector.
The seven years of the most accommodative monetary policy in history has likely played a large role in the outsized equity market returns over that time horizon. Today, after the first rate hike, and with the Fed's stated intent of raising four more times in 2016, the equities no longer have the crutch of such aggressive accommodation. Perhaps, the markets need some time to digest the price run-ups and let the earnings catch up. Wall Street is worried that the digestive period will take several more months.
With the new "transparency" at the Fed, Wall Street can now see that the FOMC is composed of uncertain humans. Under Greenspan, there was no transparency, and no decisions were ever announced or explained. Fed market actions told the story. But since the Bernanke Fed, and especially under Yellen's tenure, the uncertainty has shown through. Given all of the above worries, some on Wall Street believe the economy is far too fragile to absorb interest rate increases, especially in light of a Fed that appears so tentative and uncertain. No wonder Wall Street is worried!
The Wall of Worry
Outlined above are the main issues eating at Wall Street. The old saying - "The Market climbs a wall of worry" - is being tested today. Are there too many things to worry about? How important are these to the economy. Let's get some context.
- Labor force participation rate: This is really a non-issue and is based on a lack of understanding of the underlying data.
- Manufacturing: Poor U.S. policies have allowed the rest of the world to burden the country's manufacturers with most of the burden of the adjustment to China's infrastructure slowdown. Still, manufacturing represents only 10-12% of U.S. GDP, so a slowdown or recession in manufacturing doesn't translate into a recession in the overall economy.
- Oil: The good news is that the U.S. now has enough recoverable oil to be energy independent. The bad news for the industry is that OPEC doesn't want to give up its hegemony and has started a price war. That is good news for U.S. consumers. The oil industry represents 3-4% of U.S. GDP, and, along with the manufacturing sector, is not likely to throw the economy into recession.
- China: This is now the second-largest economy. In their transition from a bubble infrastructure economy to a consumer-driven one, they have caused a worldwide recession in raw materials and heavy manufactured goods. Much of that adjustment is likely already behind us. While Wall Street is worried, a 6% growth rate in the world's second-largest economy hardly seems to be a hard landing. Wouldn't the U.S. relish such a growth rate?
- More China: In addition, Wall Street does not like volatility in China's equity markets. But that volatility is not likely to directly impact China's real economy.
- Still more China: But the biggest worry for Wall Street, and probably the most important of all of its worries, is the impact a depreciated Chinese currency will have on U.S. manufacturers and the trade balance.
- The Fed: They likely overdid their monetary ease and stayed with it too long, causing a "wealth effect" that was more than needed. The equity markets are now having some indigestion over the outsized returns since 2009, and it may take several more months for the markets to digest. Or, we might have a market correction which will accomplish, in a short period, what months of a sideways market would achieve.
- More Fed: While there is uncertainty on display at the FOMC, that body is not composed of fools. Any indications of an oncoming recession are likely to be met with new rounds of policy easing which would bring great joy to Wall Street, weaken the dollar, help U.S. export manufacturers, and raise the dollar price of oil.
80% of the U.S. economy - the services sector - is strong. Jobs are plentiful, and many are going unfilled. At this time, a recession doesn't appear to be on the near-term time horizon - and it's recessions that cause bear markets in equities. If the manufacturing and oil sectors were healthy, economic growth would top 4%, maybe even 5%. But because they are not healthy, and they are important economic sectors, because of various issues in China, and because the Fed stayed too easy for too long, Wall Street is worried! Two things are apparent for the equity sector: 1) Market volatility will remain heightened for the next few months; and, 2) 2016 will be a stock pickers' market, and passive market strategies may not do as well as active ones.
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. I have no business relationship with any company whose stock is mentioned in this article.