Market check-in: five things to know nowDebt and low global growth are challenges; credit conditions and earnings are improving.
Fidelity ViewPoints – October 30th, 2015
Too much debt and not enough growth have been problems for much of the world since the financial crisis in 2008, and have now hit China and emerging markets (EMs). But liquidity conditions have started to improve since the Fed decided not to raise rates in September, and that has enabled markets to snap back from their summer sell-off.
These are the key takeaways from Jurrien Timmer, director of global macro, in his quarterly market webcast. Below are five highlights.
1. Too much debt, too little growth
There seem to be these rolling crises—starting with the financial crisis in ’08, then the eurozone crisis in 2011, and now China’s slowdown. The common denominator among all these issues is that we’re living in a world where there’s too much debt and not enough growth. It almost doesn’t matter which country you look at, whether it’s Brazil, Japan, China, the United States, or the euro area, there’s been a huge build-up in debt over the years. The financial crisis was not the usual type of recession, which tends to be a business cycle, inventory type. This one was a balance sheet recession, and it takes longer to recover from those. That’s why we’re still fighting deflation seven years after the crisis, no matter how low rates are and how much money has been printed. Debt deleveraging is deflationary. This is why the U.S. is still growing at only about 2% real GDP—growing so slowly that the Fed is not able to lift rates off zero without disrupting the markets.
2. China: too much debt, barely growing
China has gone through an enormous economic expansion over the past several decades, and the model for that expansion was building infrastructure and other fixed assets. A lot of it was done on credit. But now the reality is that China’s economy is barely growing, even though its debt levels have continued to soar. So each incremental unit of credit growth is generating less and less economic growth. Making matters worse is the fact that China’s currency is overvalued because it is tied to a strengthening dollar. But the more the yuan wants to come down as capital leaves China, the more currency reserves the Chinese central bank has to spend to stem that decline. This is one reason China devalued its currency in August, setting in motion the stock market correction. And it’s not just China—it’s emerging markets in general, which is why EM assets have struggled this year. A lot of corporations in the emerging markets sell commodities to China, and they have borrowed heavily in dollars. So when China slowed and the dollar strengthened, these companies got squeezed from both sides—fewer revenues and higher debt costs.
3. The Fed vs. the markets
With the Fed looking to raise rates, we were on a collision course this summer between tightening liquidity conditions in China and EMs and the specter of higher rates in the U.S. This came to a head when China devalued the yuan in August, which is when the correction happened. Fortunately, the Fed did not raise rates in September and the collision course was averted. The Fed seems justified in wanting to raise rates— after all, the U.S. economy is doing pretty well and the jobless rate is down to what the Fed believes is the economy’s inflation threshold. But the Fed seems to be far more optimistic about the economy going forward than the market is. It’s as though the Fed is saying, “We’re going to lift rates over the next couple years,” and the market is saying, “I don’t think so.” If you compare the Fed funds’ futures curve, which shows what the market is expecting the Fed to do, with what Federal Open Market Committee (FOMC) members believe the Fed is going to do, the two are very far apart. This is a story that’s been in place now for several years.
4. Credit conditions are improving
Another part of the market that weakened considerably was credit, both investment-grade and high‐yield corporate bonds. This is an important economic indicator, because it is a real‐time measure of the rates at which companies can borrow. For high-yield issuers, that credit spread widened to about 650 basis points in September. This was largely because of the energy sector, which has gotten badly hit by the decline in oil prices. But the good news is that these spreads have come down a bit over the last couple of weeks, which has taken some of the pressure off the stock market. So the strength that we’re seeing on the equity side is being supported by better action on the credit side. Credit is often a leading indicator for the stock market. It certainly was in ’08. It was credit that went first and the stock market followed. So I look very carefully at the credit markets.
5. Energy’s impact on earnings may diminish
Even though earnings growth is now slightly negative, that’s due almost entirely to energy. If you strip out the energy sector, earnings growth for 2015 is expected to grow at about 7%. So if oil prices stabilize, which they seem to be doing, then the earnings bleed from energy should diminish and the market’s overall earnings growth should converge toward a mid‐single-digit earnings growth environment. That’s not spectacular, but in today’s low-growth world, it’s acceptable.
Putting it all together
The good news is that things have become more stable in China since its currency devaluation in August. We also know that there is more quantitative easing coming from Europe and Japan, and that the Fed seems to be listening to the market by not raising rates too quickly or sharply. So the overall liquidity environment has improved since September, and that has allowed the stock market to find its footing. Even though earnings growth is negative, that’s primarily the result of falling energy prices, which should be temporary. But the structural overhang of too much debt and too little growth will stay with us for a while and is being worked through one phase at a time, with China and the emerging markets currently in the hot seat. That’s why China is in the news so much, and why it’s so important to see how the Chinese government works through its growth challenges. The other side of the coin is that the Fed may not raise rates beyond the markets’ tolerance level.
So what does all this mean for investors? Likely, a continuation of slow growth, low yields, and stock market returns that are in line with modest earnings growth. Plus the occasional deflationary shock that is part and parcel of a structural debt deleveraging. That’s why it’s important to have a good plan that’s right for you, and to stick with that plan. You don’t want to be the person who abandons a good plan when things get volatile, or you may be the one selling at the bottom
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