It's All Bad News for Markets Buckling Under China, Fed, Economy

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  • Forecasters back away from bull case as credit, economy warn
  • Less tolerance for stress in stocks priced near decade highs

Market Mayhem: How Worried Should Investors Be?

New year, same fears. Except now they’re hitting all at once. For U.S. stocks it’s meant the worst start since the financial crisis, while volatility in Europe has exploded to levels not seen in a decade.

From China’s weakening currency to the rout in oil to the withdrawal of Federal Reserve stimulus and gains in the cost of financing business, things that keep investors up at night are climbing out from under the bed again in 2016. While little of it is new, the persistence is troubling, especially when buffers such as valuations and central bank support are turning against bulls.

The result has been one of the fastest retreats from risk ever by investors coming back from New Year’s holiday. Just days into 2016, Wall Street firms from Citigroup Inc. to Royal Bank of Canada have already scaled back bullish calls for American equities this year, while single-stock analysts forecast fourth-quarter profits will shrink by more than 6 percent after predicting an expansion in August.

“The market obviously rises on the wall of fear, but right now the fear is looking a little bit more realistic,” said Brad McMillan, chief investment officer of Commonwealth Financial Network in Waltham, Massachusetts, which oversees $100 billion.

Over three days, more than $2 trillion has been wiped from the value of global equities, volatility in the broadest stock gauges has jumped 13 percent or more, and 8 percent was shed from the price of oil. Almost everything -- from junk bonds to cocoa and coffee -- has tumbled.

The rout deepened on Thursday, with China’s Shanghai Composite Index plunging another 7 percent, taking its annual loss to almost 12 percent. The Standard & Poor’s 500 Index slipped 1.3 percent at 10:20 a.m. New York time, while the Stoxx Europe 600 Index dropped 2.3 percent. In the commodity market, crude headed for its lowest settlement in 12 years.

As has been true before, the proximate cause is China. Data showing weakness in manufacturing this week sparked a tumble in the CSI 300 Index. Markets were roiled as the nation’s central bank cut its reference rate for an eighth straight day and said foreign-exchange reserves shrank by a record in December, fueling concern over the strength of the world’s second-largest economy.

China was one of the culprits when markets buckled in August, a time when the Federal Reserve had yet to begin tightening and expectations for global growth in 2016 were much higher than they are now. Another was stress in credit markets. Could the two be related?

Among the scarier scenarios laid out in August was that a drawdown of foreign-exchange reserves by central banks would starve markets of liquidity, a process sometimes called quantitative tightening. Central banks paring reserves to combat an exit of capital or manage currencies means less money in the financial system as cash is plowed into local-currency assets.

China’s defense of the yuan following the Aug. 11 devaluation contributed to the first-ever annual decline in the nation’s foreign-exchange reserves. Likewise the end of the quantitative easing in October 2014, the Fed’s five-year bond purchase program, removed one of the biggest buyers from U.S. bond markets.

That’s contributed to a rise in corporate-bond yields and a strengthening of the dollar. Higher borrowing costs will crimp profitability, expansion plans and buybacks, according to Michael Shaoul of Marketfield Asset Management LLC.

“Corporate earnings have become dependent on credit issuance and credit issuance is getting more difficult and more expensive,” Shaoul, chief executive officer of Marketfield in New York, said by phone. “I don’t think there is much argument out there why wider credit spreads would lead to pressure on corporate earnings and a lower equity market. We’ve all been through enough bad credit cycles to understand how they play out.”

The yield premium on investment-grade debt has widened 26 basis points to 173 basis points over the past six months, hovering near a three-year high, according to Bank of America Merrill Lynch index data. In junk bonds, spreads have expanded by more than 200 basis points to 711, reaching levels not seen since the European sovereign credit crisis in 2011.

China’s travails as well as contractions from Brazil to Russia are also muting expectations for global growth. The Washington-based World Bank lowered its forecast for 2016 economic expansion to 2.9 percent, from a 3.3 percent projection in June, according to its bi-annual Global Economic Prospects report released Wednesday.

And for the first time since the early 1990s, central banks around the world are pursuing divergent monetary policy, with the Fed raising its benchmark rate and the Bank of England considering doing the same. While stimulus is still flowing from the European Central Bank and Bank of Japan, it’s less than investors had wanted.

Geopolitical risks are escalating with North Korea conducting a nuclear test, tension growing between Saudi Arabia and Iran, and Britain threatening to leave the European Union.

Citigroup cut its view on American equities to underweight Tuesday as they see better opportunities in Europe and Japan. RBC’s Jonathan Golub trimmed his estimate for the S&P 500 in 2016 last month, citing the impact of oil’s plunge on profits for companies in the gauge.

Byron Wien of Blackstone Group LP predicted another down year in the S&P 500 this week, citing peak earnings hurt by margin pressure and a contraction in share-price multiples, which at 23 times reported earnings are 30 percent above the average since 1936. His forecast for 2015 proved too optimistic as the index slipped 0.7 percent.

The seven-year rally is losing speed as earnings sink into the worst decline since the global financial crisis and valuations exceed levels at the end of nine of the past 10 bull markets. Analysts see profits for S&P 500 companies dropping 6.1 percent in the fourth quarter just one week before the start of the earnings season.

“People can name more concerns,” said David Pearl, co-chief investment officer who helps oversee $43 billion at Epoch Investment Partners Inc. in New York. “We have more negative news than positive, all valid. The market is just crazed every day about something.”