Stock markets around the world took it in the pants this week. What's behind the fall? Buzzwords and phrases abound such as China slowdown, Fed Reserve increasing interest rates and collapse of rocks and oil. All true but what is the context of this? If you break it down to some core themes the following are the main themes that have brought us to this point. You can call them the Triple-D.
Deflation implies falling prices. Prices for materials and finished goods have fallen drastically in the last 6-8 months. Oil prices have been the most violent plunging more that 50 percent. Falling prices are toxic for stocks because if you wanted to buy a TV and you knew the price would be cheaper in the future you would hold off the purchase. That's not great for the company as sales would fall along with profits and subsequently stock prices as well. Another factor driving deflation is productivity gains derived from technology. As technology has automated and improved turnaround time of manufacturing and processes, the cost of producing goods has fallen. Better supply chain management means less wasted materials and inventory and thus less demand for inputs. Stock markets appear to be coming to a realization that deflation could be at hand.
There has been a race to the bottom by Central Banks around the world to devalue their currency. When deflation rears its ugly head, the game plan is to lower interest rates to stimulate economic activity to get people to bid up prices. Lower interest rates, and our current situation, ultra, next-to-nothing interest rates have forced paper fiat currencies to fall in value. Central Banks seem to be fans of this as a lower currency makes local exports cheaper and more competitive. The hope is exports will increase which will light a fire into local economies. With exception of the US reserve currency, most countries have embarked consciously or accidentally a program of currency devaluation. The most notable example and the one that everyone is blaming for the recent stock market pull back is China. With economic growth slowing, a stock market that has truly crashed, the natives are getting a bit restless and so the People's Bank of China (PBOC) has gone scorched earth and dramatically widened it's currency pegs. The market has interpreted the move as an admission that all is not well in the Middle Kingdom and possibly worse than thought.
It feels like interest rates have been rock bottom for generations. It seems to have become a constitutional right to access cheap credit. Companies have taken on lots of debt but have used it to enhance their stock prices via share buybacks and dividends versus investing back into the people and products. For the first time since the financial credit crisis in 2008, the sentiment is beginning to change as the Federal Reserve in the US has been thinking loudly on the prospects of normalizing (i.e. increasing) interest rates. Rising interest rates will make financial engineering strategies cost more and won’t provide same return. Rising rates also will crimp profits. Higher rates will lead to falling bond prices and for more high risk junk bonds the implications could be more dire. The stock market appears to be coming to grips with this and is starting to negatively price stocks with this new emerging dynamic.
These three elements on their own have not led to the pullback, but they have complemented and even supported each other. It's a pretty lethal combination and there is really no visibility on how much damage they will individually or collectively do to equity markets. Bottom line is that asset prices will adjust to reflect these new realities and at some point, opportunities will present themselves to exploit the Triple D's.