The three reasons the markets dropped in 2016
2016 started off with the worst performance in history. Fear has taken hold of the markets as if we were about to see a repeat of the financial crisis. What is going on so far this year is nothing remotely close to what happened in 2008. That financial crisis was the result of a once-in-a-generation de-leveraging across both the consumer and business economies.
In 2008, credit markets contracted, loans were repaid, spending stopped, and the economy stalled. The economy today is not seeing the same phenomenon. In 2016, banks are still lending, albeit restrictively, consumers are still borrowing, and the credit markets are still active. Banks have far stronger balance sheets today, central banks around the world have much better crisis-prevention systems in place, and businesses and consumers carry far-less debt than they did eight years ago. For all these reasons, 2016 is not like 2008.
We have three main reasons that currently unsettle the markets.
The price of oil is too low.
Oil prices are at their lowest levels in more than twelve years, trading at around USD 30/barrel. The current prices are wreaking havoc on the energy sector and that stress is trickling through to lenders and related industries. The oil markets are reacting to slowing demand from China and excess supply from new sources like the U.S., and unabated pumping from Middle Eastern players. Lower demand and oversupply inevitably leads to lower prices.
Interestingly, research indicates that some 40% of all oil-market trades are from speculators, not actual producers or consumers. This means two things: first, low prices from heavy speculation is not reflective of real world economic problems, and second this is not the type of event that could crash the economy like the credit crisis did in 2008. Such speculation can exaggerate, or even disrupt, the true balance of supply and demand. We saw similar wild swings in 2008 and 2009. The drop in prices quickly recovered, essentially doubling each of the next two years.
Many analysts are predicting that oil prices are likely to remain low for some time. On the other hand, do not be surprised if oil were back to USD 80-90 a barrel by this time next year, or the year after. Recent history has shown that these kinds of reversals are possible, and with such high speculative interest, it seems quite plausible.
2. China’s economy is slowing
The world has become accustomed to 8 to10% growth rates from the Chinese economy. Now, however, it looks like expectations going forward should be more like 4%-6%. The latest official growth rate was 6.9%. China's economy is changing from an export-driven model to a consumption-driven one, while also dealing with a serious demographic problem. You would expect some hiccups when the world's second-largest economy goes through such a big structural transformation.
This economic transformation leads to a market correction as investors adjust their positions. With hindsight, this transformation and correction of the markets are likely to be seen as growing pain, and short-term in nature in the future.
3.The end of the near-zero interest-rate policy
The Fed finally raised the Federal Funds rate by a tiny step from 0% to a 0.25% target. The market has waited for this moment with great trepidation for several years now. Every time the markets got wind of a rate hike over the past two years, the major indices spiked lower. However, the market's fear may not be driven by economic fundamentals. Inflation is well in check, the labor market is looking better, and GDP keeps on growing slowly, but surely. Fundamentally, raising rates is a good thing as it means that the economy is healthy enough to not need all this central bank assistance anymore. After eight years of a very accommodative stance, the central banks would be hard-pressed to raise rates unless they were confident the economy could handle it.
The bigger challenge for the Fed is managing expectations and group psychology. There are major investment funds trading everyday with borrowed money that carries a next-to-zero interest rate. The broad concern is that, in a higher-rate future, these big players will sell their equity positions and put their capital into other asset classes. If that happens, the big-money selling would drive down stock prices. This is the "equity asset bubble" you will hear about in the financial media.
There is a legitimate concern with this argument, and it is also true that higher rates will be a headwind to business investment, lending, and all the other credit-related economics that make the world turn. For example, the dollar has been strengthening against global currencies over the past 18 months as investors have been anticipating the rate hike. The strong dollar is hurting U.S. exports, and will probably start to show some impact on the bottom line for US corporations with global sales. If profits dip at these companies, that could spook the market, and trigger a sell-off.
That would be another short-term problem. As the economy continues to grow, the natural rhythm of interest rates and currency markets will eventually find balance, making the current issue a short-term hiccup on the long-term growth trend.
Low oil prices have forced certain big-money funds to sell off equity positions, and that, coupled with the bad headlines from China and the concern over higher interest rates, combined to form the perfect storm. Markets tumbled, and fear replaced reason.
What to do with your investments?
It is easy to forget in a fearful time that the S&P 500, by historical standards, is still close to all-time highs. Since 2010, the market has been on an absolute tear upwards, and it would not be a bad thing if the market did pause for a short-term correction. This is the way the markets have always worked, and there is no reason to think anything has changed now.
There is fear in the markets right now, but that fear is not based on anything scary for a long-term investor.
If your investment horizon is longer than just a few months or a couple of years, you should not be worried. If anything, today's fear may be your entry signal.