5 Reasons Why the Global Meltdown is Just Getting Warmed Up
Late last year I wrote an article suggesting the U.S. could enter a depression in 2015. To some it sounded farfetched at the time. After all, the stock market was at record highs and investors remained bullish. But it seemed to me that all the economic evidence pointed to a U.S. financial crisis. I think the same conditions are in play. In fact, I think the global meltdown is just getting warmed up.
Central Banks Run Out of Tricks
When the financial crisis circled the globe back in 2008, the Wharton grads running Wall Street looked to the Federal Reserve to bail it out. Privatize the gains and socialize the losses!
So began America’s love affair with Ben Bernanke, the overly generous sugar daddy. Not to be outdone, central banks around the world have stepped in to save the global economy; lowering interest rates in an effort to kick-start the economy. From China, to Canada, to Brazil, to the ECB, India, Bank of England, and Denmark National Bank, central banks chopped interest rates to shore up their economies.
In the face of weak economic data, the low interest rates helped fuel stock market booms. Which, as we have seen, have turned to busts. The solution? Lower interest rates even further. Boom. Bust. Repeat.
After trillions of dollars in quantitative easing efforts and interest rates at record lows, what do we have to show for it? A global economy on the verge of collapse. In fact, the global economy is no better off than if the central banks had done nothing.
And with global economies reporting anemic growth, the central banks have run out of save-the-day monetary policies. With interest rates low for so long, what can central banks do now to help their respective economies?
That’s right. Nothing.
U.S. Stocks Overvalued
Artificially low interest rates accomplished two things. It made it cheap to borrow money. It also took “income” out of income investing. Those nearing retirement could no longer rely on fixed income investments like treasures, bonds, and CDs.
What to do, what to do… Borrow money and dump it into the stock market. No matter what. Between March 2009 when the markets bottomed and May 2015, the S&P 500 soared 220%, while the Dow Jones Industrial Average gained a respectable 183%.
Despite weak economic data, investors sent the markets higher. Case in point; in 2013, U.S. gross domestic product (GDP) growth was just 1.9%. The S&P 500, on the other hand, climbed approximately 30%. How did those companies on the S&P 500 fair? During the first quarter, 78% of S&P 500 companies issued negative EPS guidance; during the second quarter, 81% of companies issued negative guidance. In the third quarter, a record 83% of all S&P 500 companies revised their earnings guidance lower. That record fell in the fourth quarter when 88% of companies that provided preannouncements issued negative earnings guidance.
Normally, one rewards companies for increased earnings and revenue. Not anymore. Investors reward companies for not losing as much as they thought they would.
Fast forward to 2015 and little has changed. Fundamentals continue to be weak. According to the most recent data, companies on the S&P 500 experienced a one percent decline in earnings. It doesn’t sound like much, but it’s the first decline in profits since the third quarter of 2012. During the third quarter, S&P 500 companies reported a 3.3% decline in revenue. This is the first time since 2009 that revenues for companies on the S&P 500 have declined for two consecutive quarters. (Source: factset.com, September 1, 2015.)
Again, despite weak results, the markets continued to trade near record highs. At least they did until Black Monday. But even that precipitous drop wasn’t as catastrophic as it could have been.
After the shock of Black Monday, the markets continue to be resilient. Sure, they’re teetering on correction mode. But even still, it’s all relative. The Shiller CAPE PE ratio for the S&P 500 stands at 27%; 58% above its historic average of 17. The ratio has only been higher three times: 2007, 2000, and 1929. In each instance, the stock market collapsed soon thereafter.
Where should the stock markets be to be fairly valued according to Shiller? His ratio would put the S&P closer to 1,300; with the S&P currently at approximately 1,915, it could fall as much as 32%. The Shiller ratio also puts the Dow at 11,000 from around 16,050, suggesting a well-earned, precipitous fall of 31%. (Source: nytimes.com, August 27, 2015.)
The market cap to GDP ratio, affectionately referred to as the Warren Buffett Indicator, stands at 118%. A reading of 100% suggests stocks are properly valued. A reading over 115% suggests stocks are significantly overvalued. To put it into perspective, the ratio has only been higher once since 1950—that was in 1999.
China is the world’s second biggest economy. Which might explain why continued weakness in the economy that helped the world stave off a global recession in 2008 would send stocks into a tailspin.
A little more than a week later, and data on China’s manufacturing sector, falling to a three-year low in August, suggests the country’s economy is doing worse than expected. The country’s official manufacturing purchasing-managers index (PMI) fell to 49.7 in August from 50 a month earlier. A reading above 50 suggests expansion in manufacturing activity where a reading below 50 points to a contraction.
The government’s non-manufacturing PMI also fell on a month-over-month basis from 53.4 in August to 53.9 in July. (Source: wsj.com, September 1, 2015.)
China has said it expects to reach its growth target of seven percent this year. While this sounds solid when compared to the U.S. economy, that would still represent the worst performance in more than 20 years.
This happened despite slashing interest rates five times since last November (to 4.85%) and a surprise devaluing of the yuan. Unfortunately, making the currency weaker in an effort to boost exports will only work if people on the other end have money to spend. They don’t, really.
With the U.S. being the world’s biggest economy and China as the second-biggest economy, along with the rest of the world’s major economies underperforming, the collapse in commodities can’t be that much of a surprise. And thanks to OPEC, the slide in oil prices is even more pronounced.
Light crude has been falling since last June, save for a brief, unsustainable rally in the spring. Currently trading near $48.00 per barrel, oil is still at multi-year lows. Brent crude is also hovering at multi-year lows of about $52.00 per barrel.
Like oil, the correlation between copper prices and the stock market has been a reliable indicator of economic health. Copper is currently trading near $2.30 per pound and has been in sharp decline since 2011. By comparison, the S&P 500 has been bullish. This negative correlation does not bode well for the stock market.
Iron ore, like oil and copper, is essential for any growing economy. But iron ore prices are in freefall. Iron ore prices have fallen to around $52.95 per tonne, a fraction of the $140.00 per tonne it commanded in early 2014. And significantly below $187.00 per tonne in early 2011.
When the two largest economies in the world are faltering, you know the rest of the major economies cannot be far behind. The eurozone continues to teeter on the verge of a recession. Germany continues to forge ahead and Spain is back on its feet. But France, Italy, and Greece are economic milestones.
Japan’s economy shrank 1.6% in the second quarter. But fear not, the country’s Economy Minister, Akra Amari, said the contraction is most likely a one-off, pointing to strong air conditioning sales in July and August. Phew—the air conditioning ratio comes through in the clutch.
Or maybe not. Since 2012, Japan’s growth has been a roller coaster or pogo stick. Over the last 14 quarters, Japan has posted seven quarters of growth and seven quarters of contraction. (Source: wsj.com, August 16, 2015.)
Then there’s Canada. Statistics Canada reported that the country’s GDP fell 0.5% in the second quarter after falling 0.8% in the first quarter. It’s not a resounding recession, more the definition of a technical recession.
Still, it could be more damaging to the U.S. economy than what’s going on in China. That’s because Canada is the U.S.’s number one export market, accounting for 19% of all exports. That’s more than double China’s seven percent share.
On top of that, Canada’s resource-heavy dollar has been in freefall, down 12% against the U.S. dollar since the beginning of the year. The Chinese yuan on the other hand is down just three percent.
Taken collectively, this does not look good for the U.S. economy. It also points to continued pressure on the global stock markets. Remember, stock exchanges are only as strong as the stocks that make them up.
And with the global economy in a tailspin and no one major economy able to carry the world on its shoulders, the outlook remains bleak. What can central banks do to kick-start the economy this time? Not much. Interest rates are still low from the last recession.
Also Read: Global Financial Crisis 2015 Explained: How It’s Affecting the U.S.