This Week's Preview: Stay On The Sidelines

Summary

• Last week was a tough one for the S&P-500 and Dow Jones, due in large part to mounting concerns regarding China's economic growth.
• Last week, we didn't get any significant economic data from China, but this week, we'll get the latest trade numbers that may not look good.
• The turmoil in China may continue to impact US markets.
• The US earnings season will also kick off from Monday when Alcoa announces its results.
• The materials and energy sectors may continue to drag the S&P-500.

Last week marked the worst start of the year for global equity markets ever. Virtually every S&P-500 sector closed in red on Friday. The SPDR S&P 500 ETF (SPY), which tracks to S&P-500, and the SPDR Dow Jones Industrial Average ETF (DIA) which follows the Dow Jones, have dropped 5.8% and 6.2% respectively. The worsening geopolitical landscape, with North Korea claim regarding a successful hydrogen bomb test and growing tensions in the Middle East, has not helped. But the sell-off has been fueled in large part by fears related to a global economic slowdown in general and China in particular.

China's Shanghai composite plunged 6.9% last Monday, due to growing concerns regarding Yuan's devaluation, followed by 7% drop on Thursday. The latest drop prompted Beijing to suspend the four-day old "circuit breakers". The mechanism, which halts trading for 15 minutes following a 5% drop in CSI 300 and suspends activity for the day after a 7% decline, was meant to reduce panic selling, but seems to have 5trrrfexacerbated the sell-off - which was also partly admitted by Chinese regulators.

But more importantly, the drop in China's equity markets is the latest in a series of self-inflicted wounds which include the significant crash in mid-2015 and yuan surprise devaluation in August. Such events have highlighted policy miscalculations and raised concerns about China's commitment to reform its financial markets and competence of the policy makers. No wonder US investors seem to be losing whatever faith they had in China's equity markets, and by that extension, Chinese companies that trade here in the US.

Last week was a quiet one in terms of economic data from China, but on Wednesday, we'll get the latest trade balance numbers. The nation's trade with the rest of the world has been going downhill, with the previous report showing another drop in exports for the fifth time in a row. The country's trade surplus shrunk to $54.1 billion in November from $61.6 billion in October, missing market's estimate of $62.8 billion. This time, analysts have projected a drop in surplus to $53 billion, according to data from the financial spreadbetter IG. The weakness could reinforce concerns regarding China's economic growth. In other words, the rout in China's equity markets may not be over.

It is important to note that the weakness in China does not meaningfully impact US economy in general, and this has been firmly established over the last couple of years. At a time when China has been gradually losing steam, which was evident in its latest third quarter GDP numbers that showed slowest growth over the last six years, the US has improved to a point that it no longer needed the Fed's bond buying program and zero interest rates. (We'll get China's full year and fourth quarter GDP data next week, on January 19)

That being said, it is also difficult to ignore the link between a number of S&P-500 companies and China's economy. For instance, nearly every US listed company operating in energy and basic materials space, ranging from Exxon Mobil (XOM) to Alcoa (AA), has felt the impact of slowing economic growth in China that has hit the demand for a number of commodities. Thanks to the soft commodity price environment, the energy and materials companies witnessed 56.8% and 15.8% decline in earnings in the third quarter, which led to 1.5% drop in earnings for the broader S&P-500, according to data from FactSet.

The fourth quarter earnings season in the US will begin from this week, with Alcoa reporting its fourth quarter results after the markets close on Monday. Due to persistent weakness in commodity prices and mounting concerns regarding China's economic growth, this could be another dismal earnings season. FactSet has projected 5.3% decline in S&P-500 earnings for the fourth quarter which will be, once again, led by weakness in the materials and energy sectors. A decline in earnings would mark the first time that the S&P-500 earnings have fallen for three straight quarters since Q1-Q3, 2009.

Due to the pessimism, I believe that the SPDR S&P 500 ETF and the SPDR Dow Jones Industrial Average ETF could remain under pressure this week. Investors should, therefore, stay on the sidelines and watch the China-led turmoil play out.

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.