July 2nd is usually optimistic because it is the exact middle of the year. The second half of the year starts today, and hope springs eternal. Typically, the first half of July sparks a brief summer glow, a rally that gives some lift to the market for 1-3 weeks. The start of this year was the worst for global stock markets since the Great Recession, and the start of the second half of the year appeared not much better at first. Markets were a sea of red across the globe this morning, including the S&P 500 and the Dow:
The stock market’s drop Monday is showing panic-like characteristics for the first time in three months, according to the NYSE’s Arms Index, which is a volume-weighted breadth measure used to gauge the intensity of buying and selling. The Arms, which tends to rise above 1.000 when the broader market falls, hiked up to 2.254 in afternoon trade. Many technicians view rises above 2.000 to indicate panic-, or capitulation-like, selling. The number of declining stocks outnumbered advancing stocks 1,781 to 1,114, or by a ratio of 1.60 to 1. Meanwhile, volume in declining stocks was 235.1 million shares versus 65.2 million shares of advancing stocks, for a much higher ratio of 3.61 to 1. (MarketWatch)
If bulls were hoping to get a little bounce to push things back in the “right” direction today, they caught a glimmer of that at the end of the day. For most of the day, the bears were in ascendancy as the sun crosses the midpoint of the calendar year. In the end, it was only tech stocks (again) that saved the day — particularly the FAANG stocks that have driven the market for years. (It is almost as if there is a tacit agreement that has developed among investors or algorithms that “We’ll always bid up those five stocks at the end of the day to assure a save.”)
The Dow ended up by a hair at 0.1%, and the S&P closed up 0.3%, essentially at its average close for July 2nd, and the Nasdaq, which is heavily weighted toward tech stocks, closed up 0.8%. However, the general investment news of the day sounded mostly concerned:
“That we’re starting the second half of the year on a down note is really telling. This is usually a slow week with the holiday, but there’s definitely color in the market that is causing it to be volatile,” Mark Esposito, president of Esposito Securities, a Dallas-based asset manager. (MarketWatch)
World Trade War
The main factor weighing on markets all over the globe on this normally beautiful summer day was clearly Trump’s developing world trade war. It didn’t help the bulls case that Trump’s trade negotiator in chief announced at the top of the morning that a falling stock market would not change Trump’s course on trade tariffs. The Secretary of Commerce, Wilbur Ross, said that Trump does not determine trade policy based on the stock market. He even went as far as to say …
The commander-in-chief won’t change his mind on hard-line policies no matter how far the Dow Jones industrial average plunges. “There is obviously going to be some pulling and tugging as we try to deal with very serious problems,” he continued. “There will be some hiccups long the way (NewsMax)
According to Ross, there is no level of the stock market that would cause Trump to pull back from the precipice of a global trade war.
Today’s problems in the market were made worse by the EU’s threat to impose tariffs on almost $300 billion worth of US trade if the US imposes auto tariffs, as Trump has said will happen. That amounts to a tariff on almost 20% of US exports.
Europe sent the threat to US authorities in a letter dated Friday, which hit the news cycle today. Trump stepped up his rhetoric, turning it into the largest trade attack on America’s allies to date by saying that Europe “is possibly as bad” as China in trade practices. A low blow to be sure. We all know China is horrible and deserves a trade war, though such a war can be economically disastrous for everyone involved.
More than threats — factories down
It is not just the threat of tariffs that caused the market to open down about 160 points in the Dow. Tariffs and the threat of tariffs have already turned down actual factory production. Manufacturing is down in Europe and Asia. European factory growth — including Germany’s own growth rate — is at an 18-month low. Factories in Europe are adjusting production for a slowdown during the remainder of the year because of the tariffs.
The downshift is already broad-based, extending throughout Europe and across most of Asia. Chinese and Japanese shipping are already declining. So, the gearing down is happening even before the tariffs have hit. China has seen export orders decline for three months now. Japan is seeing export orders contract as well. The very real effects of tariffs are coming on almost instantaneously with the threats of tariffs. How much more real will the effects become as the tariffs are actually implemented?
The downturn is happening right as the central bank in Japan is wanting to turn down its stimulus printing of money. Central banks in all of those nations are also paralyzed from much hope of keeping interest down due to rising rates in the US, which could cause a flight of capital from European and Asian nations if their interest rates stay much lower.
And, while, manufacturing is not yet contracting in the US, the PMI figures released today show that its growth is slowing down to its lowest level since February with new-order growth at its weakest since November of last year.
Hedges go up as investors seek cover
Money managers say that mounting barriers to trade between the United States and trading partners — Washington’s latest proposal for tariffs on $675 billion of Chinese goods is expected to elicit a response from Beijing — is prompting them to look for ways to protect profits in the event equity markets take a dive after years of growth. (NewsMax)
Trade isn’t the only issue weighing on investors’ minds. European growth has lost steam, oil prices are near $80 a barrel while the U.S., European and many emerging central banks are tightening monetary policy. And politics could exacerbate any downturn, with Germany’s coalition in uproar over migration, and Italy’s new government flirting with a big-spending, possibly eurosceptic, agenda.
So much for all that flowery nonsense about “globally synchronized growth” that we heard all over the media at the end of last year and during January of this year. That didn’t happen, and the 4-5% growth in US GDP that the Fed was predicting for the second quarter is rapidly being revised downward, too. It may not go down a lot because the downtrend didn’t start becoming clear until the last month of the quarter, but it is weighing the quarter’s total down. So projects of US GDP, too, may have been a delirious mirage. We’ll see when real number come out.
Of course, as the risk of a market crash goes up, the cost of hedging against that crash also goes up. Thus, the rise in the cost of hedging is a measure of the rise in perceived risk in markets. The cost of hedging Germany’s DAX index, for example, has gone up because Germany is very exposed to trade-war risks. Euro Stoxx 50 Volatility Index has soared to all-time highs.
Similar action is now being seen in the US with investors now purchasing stock options that hedge against a drop of 10 percent or more in U.S. indexes.
Open interest … on put options on the S&P 500 index falling around 10 percent from current levels maturing in the next two weeks is far greater than on other options, according to Thomson Reuters data. (NewsMax)
These are very bearish signs that investor sentiment is sliding into the fear zone. Thus, the cost of “insurance” is getting steep, and some brokerages are counseling investors to buy protection in markets outside the US where central-bank easing (liquidity) is still propping up some markets at home.
We haven’t hit February’s highs in volatility yet, but we’re halfway there, and the second half can come in a day if fear takes the next step into panic.
Buybacks and dividends failing to overcome Fed’s Great Unwind
Buybacks and dividends hit a record level in the first quarter of the year, surpassing even the previous high-point that happened right before the economic crisis that took us into the Great Recession. At $189 billion, they exceeded the $172 billion fever pitch that was hit in 2007. These have been largely funded by Trump’s tax cuts where repatriation brought over $300 billion of cash back into the country in the first quarter alone.
And, yet, these record buybacks failed entirely to pump up the market. As I’ve maintained here, the Federal Reserve’s downdraft as it exits its Great Recession recovery mode will become so extreme that it even overwhelms the positive effect of tax cuts and of buybacks and dividends. That, I’ve said, would start happening in the beginning of the year but would probably not become real apparent until … well, now.
With first-quarter data just released, we can now see how true that was and is. The bull market of the long “recovery” period was goosed almost relentlessly upward by $4 trillion in stock buybacks! Those buybacks in the first quarter reached even higher (I would say euphoric) levels; but with the Fed’s drains opening wide, they are no longer able to push the market up. They are doing a wobbly effort at just propping it from falling furrther. The market tanked in the first quarter and has struggled and failed to regain its lost ground ever since.
The only area where buybacks have helped was in the sector where they happened the most all along — the sector that has managed throughout the “recovery” to provide most of the market lift — technology. But even technology appears no longer able by itself to carry the overall market totals to new highs. Health Care, the next highest sector for buybacks, saw only 1% growth over the entire first half of the year — so almost nothing. (Negative when inflation is factored in now that inflation has slightly edged past the Fed’s 2% annual target.) All other sectors are down.
Even the inflows from other failing national markets are (so far) failing to lift US stocks. Combined with buybacks, they are slowing down the fall, but not lifting stock prices up.
The Fed’s Great Unwind drives everything
Never bet against the Fed, they say. So, why would you now? The Fed has stated that it knew it was driving up stocks by giving new money to banks to invest, and that it was doing this as its intentional goal to try to create a “wealth effect” throughout the economy. That is what drove stocks up in this ridiculously inflated manner where earnings only look reasonable in supporting prices because share buybacks are continually taking down the denominator (the number of shares) over which earnings get divided.
So, don’t let trade wars cloud the picture. Yes, they are a major factor in taking the market down right now. Back in January, however, it was concerns about rising bond interest and inflation. In the next leg it, will be something else. The market is coming down because “what goes up must come down” when the thrust that was driving it up is reversed. Simple as that. As Phoenix Capital explains,
When the Fed began its attempt to normalize policy with its first rate hike in 2015, it represented an attempt to “pass off” this role to the real economy.
When the markets remained elevated, the Fed then decided to accelerate the pace of normalization [by] hiking rates more aggressively while also introducing Quantitative Tightening (QT) in an attempt to shrink its massive $4.5 trillion balance sheet.
At first, the impact of QT was overshadowed by the fact that the European Central Bank (ECB) and the Bank of Japan (BoJ) were engaging in QE programs of $150+ billion per month. In this context, the fact the Fed was engaging in QT of $10 billion had little impact.
However, fast forward to the end of 1Q18, when the Fed increased the pace of QT to $30 billion per month at the same time that the BoJ and EBC had begun tapering their own QE programs, and the market took note….
Thus far, the US stock market has held up relatively well. But this is where it gets really REALLY bad. The Fed will raise the pace of its QT program to $50 billion this month. And it’s doing it at the same time that the ECB is dropping its own QE program to below $30 billion per month.
Put another way, this is the FIRST time since 2008, that global market monetary policy will be NEGATIVE: more money will be leaving the system via QT, than will be entering it via QE.
With that in mind, the S&P 500 is on VERY thin ice. It MUST hold its trendline (blue line) and critical support (red line) or it will be joining the Emerging Market space in a 20% drop.(Zero Hedge)
Here’s Morgan Stanley’s picture of what is happening right now with central banks backing away from quantitative easing:
Morgan Stanley even goes so far as to suggest that the reason gold prices and crypto currencies are coming down right now is that desperate investors are selling off what they have in those assets to try to settle claims against them in the stock market now that the Fed’s efforts are making loans for such purposes more expensive. According to Morgan Stanley cash is becoming “dear” because of central-bank tightening (and particularly the Fed’s bond roll off). That process by the Fed is just getting up to speed now and will be converging with other central banks in the months ahead.
The way Phoenix Capital describes the unwind process and what will befall those efforts is the way I’ve been laying the scenario out, too. The first runs at minimizing the Fed’s balance sheet would be felt earlier in the year (as they were), but the effects would be muted at first by the new tax breaks, huge stock buybacks resulting from repatriation of cash, and the fact that only one central bank was unwinding and not very seriously at first. The Great Unwind would not start to become starkly obvious until early summer when the pace of the unwind really picks up. Well, here we are, so keep watching to see if that was right