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How Low Can It Get?

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Monday, June 24, 2013

Chinese stocks suffered the biggest sell-off overnight in more than four years as the short-term funding issue in that country’s banking sector is morphing into a cash crunch for the economy. The Chinese central bank could very easily address the issue, but it is reportedly staying on the sidelines with the explicit goal of shaking out the shadow banking sector, which had become a source of aggressive credit creation in the economy.

We will see how this issue unfolds in the coming days, but this funding issue adds to the growth questions about China that the markets were already trying to grapple with. Growth estimates for China’s GDP have started coming down lately which is having knock-on effects in a range of commodity markets.

China may be in the headlines today, but the biggest  source of market volatility at present is the Fed’s changed monetary policy stance. The spike in benchmark treasury yields is the most tangible outcome of this changed backdrop. The Fed’s QE program kept interest rates low, by some estimates roughly half the level where they would be otherwise. Interest rates still remain low by historical standards, but the ‘normalization’ process has been very swift thus far – an almost 100 basis points jump for the 10-year treasury bond yield in the last few weeks. Higher yield levels by themselves may not be that destabilizing, particularly for a recovering economy. But the speed with which yields rise could be problematic and that’s what has the markets most unnerved at this stage.

The consensus view appears to be that there is not much downside to this trend – that stocks have dropped about 5% from the May high and will drop a few more percentage points to roughly in the 1550’ish level for the S&P 500 index. To back up this view, all kinds of technical support levels and moving averages get cited. May be these folks are correct, but I am a lot less sanguine about the market’s near-term trend.

I don’t see the market stabilizing till it reaches the low 1400’s, may be even a bit lower. Investors overlooked the lack of earnings power over the last few quarters with the help of QE. But with that prop no longer available, they can’t escape the reality of a very underwhelming earnings picture. Multiple expansion gave us the rally, but that is now firmly in the rearview mirror. The gains going forward will need to come from earnings growth. But unfortunately the earnings growth story may have already played out as well.

Sheraz Mian
Director of Research


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