Stock markets are slipping the leash from central banks. After six-year-long bull market sustained by lashings of central bank money, August is shaping up to be the weakest month for global equities since May 2012 – despite a ramp-up in bets that interest rates will stay lower for even longer.
The danger is the correction turns into a rout. China’s economy, for years the driver of global growth, is slowing alarmingly. Its currency devaluation, along with slumping oil prices, has reignited global deflation concerns and fears of global “currency wars”.
Some weak economic signals from the United States, too, have pushed back expectations of U.S. rate hikes – but with none of the jubilation usually associated with easy Federal Reserve policy.
If the world economy is slowing down at a time of lofty stock prices, then market valuations need to come down, some say.
“This is a test of the old regime. It is the first time where we have seen growth fears trump the prospect of more liquidity, as interest-rate hike expectations get pushed back,” said Nick Lawson, Managing Director at Deutsche Bank.
“The multiples we are being asked to pay for equities are increasingly out of step with the growth outlook.”
Forward price-to-earnings ratios for U.S. and euro zone equities are above their historical averages at 16.7 and 15.6 respectively. While the second-quarter earnings season supported expectations of more profit growth to come, European corporate profit margins remain below their U.S. counterparts.
The big worry now is that China’s slowing growth and weakening currency will stoke deflationary pressures around the world. Its factory sector shrank at its fastest rate in almost 6-1/2 years in August, a private survey showed on Friday.
Citi economists this week cut their 2016 global growth forecast to 3.1 percent from 3.3 percent, the third downward revision in as many months. “Risks to our 2016 growth forecasts probably remain to the downside, especially reflecting China worries,” they told clients.
ROLL IT OVER
As a volatile summer approaches its final trading week, the weakness in emerging markets is spreading to developed markets: Germany’s DAX is on track for its worst month since 2011 and the S&P 500 is now negative for the year.
The S&P 500 is over three times its level in early 2009 and the DAX has made similar gains. That means there is potentially a long way to fall.
Larry McDonald, senior director and head of U.S. strategy at Newedge in New York, says the U.S. market will eventually succumb to the growing global pressures.
He points to market “roll overs”, or number of days between corrections of 5 percent or more. The two longest “roll overs” in recent years on the S&P 500 were 155 days in 2011 and 66 days in 2010, and were immediately followed by 10 percent and 8 percent falls, respectively.
The current “roll over” is around 90 days and the S&P is around 4.5 percent below its record high struck in July, McDonald said.
“That’s testament to the resilience of the bulls. It’s a sign that the bulls are fighting and buying the dips. But when that breaks, that’s when you get the big downdraft. We haven’t had that since 2011,” he said.
McDonald expects that break to come. When it does, it will take the S&P 500 firmly below 2,000 points. It is currently not far off that level at 2,035.
To be sure, it’s not all bad news: euro zone business growth unexpectedly accelerated this month thanks to a strong rebound in Germany, and traders are quick to caution that summertime activity is light and rarely a good indicator of the true pulse of investor sentiment.
But money is flowing out of the market: fund flow data from Bank of America Merrill Lynch showed that investors pulled $8.3 billion from equity funds in the week ending Aug. 19, the largest outflow in over three months. Year-to-date equities flows are up only 0.4 percent.
“There was a time when bad news, whatever it was, was good news,” said Anthony Rayner, a portfolio manager at Miton Group. Now, “for me, the key risk is the credibility of central banks. As people focus on what growth we are getting, their options look fairly limited.”