Investors who needed proof of China's increased importance in the post-financial-crisis world only have to look at the nervousness of recent weeks to get a glimpse of the future.
When U.S. stocks fell sharply late Friday, they capped off a harrowing 10-day span that has seen the broad U.S. market benchmarks drop by nearly 7%. Emerging markets are down 9%. Not surprisingly, investor fear has sent volatility rocketing 40% – the largest two-week increase since the global financial crisis went nuclear back in October 2008.
Complicating matters was the continued strengthening of the U.S. dollar – something we've been discussing and warning about for a few weeks. With fear on the rise among global investors, many are abandoning risky positions in emerging-market stocks and bonds and moving cash into the safety of U.S. Treasuries. This bolsters the dollar, which was up 4% in two weeks. That exerts a lot of pressure on commodities. Crude oil fell more than 7% during the week. Gold is down 5%.
The corporate bond market – which has been red hot lately, helping to underpin stock-market gains – continued to advance, but slipped relative to ultra-safe government debt. Tim Backshall of Credit Derivatives Research wrote in a note to clients that both high-yield and investment-grade credits have been making the longest and most consistent run of lower lows versus ultra-safe U.S. Treasuries since February 2008.
While government debt has the edge for the moment, the long-term corporate-credit bull market remains intact, according to WJB Capital Group Inc. strategist Brian Reynolds. He sees the credit bears making a run at credit-derivative products that insure against bond defaults, which are a cheap way to try to manipulate the market.
Indeed, the cost to protect against default at banks like JPMorgan Chase & Co. (NYSE: JPM) and Goldman Sachs Group Inc. (NYSE: GS), not to mention Greece, jumped noticeably last week. But the damage has been limited as bears have failed to get traction against the instruments that they used to catalyze the 2008 credit crisis.
This lays the groundwork for a powerful snapback rally for stocks.
The China Surprise
Investors have faced a litany of worries lately. The combination of new unforeseen and uncomfortable variables has shocked people out of complacency. And that's why last week's reaction was so dramatic.
Many of the assumptions that have underpinned the steady low-volatility rally out of the March 2009 low have been shaken. Assumptions like steady-and-solid growth from China. Assumptions that Wall Street's return to big profits wouldn't be interfered with. Assumptions that politicians are loath to do anything that would upset markets after the big scare back in September 2008, when the U.S. House of Representatives rejected U.S. President George W. Bush's financial bailout package.
There were amplified concerns over credit tightening in China as policymakers there continue to fight runaway loan growth, a frothy real estate market, and emerging inflationary pressures. The iShares FTSE/Xinhua China 25 Index Exchange Traded Fund (NYSE: FXI) has fallen under its 10-month average, which is the lower boundary of a bull cycle. Closing beneath that support is at minimum a yellow flag for the rally in emerging markets stocks.
A second monthly close under that level would seal the deal. It's serious stuff.
How could that happen when the Chinese government just reported fourth-quarter gross-domestic-product (GDP) growth of 10.7%? That sounds awesome at first until you consider that the bureaucrats running the show over there are targeting growth of 8%. This "overheating" is resulting in inflation: Consumer price inflation jumped 1.9% year-over-year in December from 0.6% in November and is expected to rise to 3% as soon as February.
Inflation is terrible news for China and has historically been a source of social unrest. Food prices are a much more significant portion of the average Chinese family budget than they are for households in the West, so the fact that vegetable prices rose 16% between November and December is cause for great concern.
As a result, analysts at Capital Economics believe the first official interest rate hike out of China could come as soon as early March – which just so happens to coincide with the ending of the U.S. Federal Reserve's direct-bond purchase program.
Since China is the lender of last resort in the world – as the Bank of China has purchased hundreds of billions of dollars worth of corporate and government debt in Europe and the United States at distressed prices – rate hikes by that country's central bank may actually mean more than most Western observers have been thinking. They carry a lot of weight.
It's possible that when optimists decided not to worry about the U.S. Federal Reserve raising rates this year, they were focusing on the wrong central bank. The bottom line: It seems the world markets last week decided to price in interest rate hikes as a matter of grave importance, and are relegating European Central Bank (ECB) decisions to second-tier status, and perhaps the same for the Federal Reserve. If this is true, it's a shocker – and a harbinger of a new era.
The Week in Review
Monday: Existing home sales dropped more than expected in December, at an annual rate of 5.45 million units. Compare this to the 5.9 million-consensus estimate and November's 6.5 million result. The expiration of the now-extended first-time homebuyer tax credit was blamed for the slide.
Tuesday: The latest Case-Shiller home price data indicates that the home price recovery has stalled. The index dropped 0.2% for November following a 0.1% drop in October. Separately, consumer confidence for January increased more than expected, as people slowly get more optimistic about the job market.
Wednesday: A busy news day in which Apple unveiled a new tablet computer, Congress grilled U.S. Treasury Secretary Timothy Geithner and his predecessor, former Treasury Secretary Henry M. "Hank" Paulson Jr. about the American International Group Inc. (NYSE: AIG) bailout, details of U.S. President Barack Obama's first State of the Union address leaked and the Federal Reserve announced it would leave interest rates unchanged. New home sales for December came in under expectations thanks to the previously mentioned expiration of those first-time homebuyer tax credits.
Thursday: Economic data came in lighter than expected, as durable goods orders for December rose just 0.3%, a far cry from the 2% jump expected. Meanwhile, initial jobless claims for the week of January 23 fell by 8,000 from the prior week to 470,000, but that again was higher than the 450,000 analysts expected. Continuing claims were also a bit higher than expected, at 4.6 million.
Friday: A batch of solid economic news. GDP expanded by a better-than-expected 5.7% in the fourth quarter. The Chicago Business Barometer increased more than expected, rising to 61.5 vs. the 57 consensus estimate thanks to a flood of new orders to manufacturers in the Midwest region. Any reading over 50 indicates expansion.
The week ahead
Monday: The ISM Manufacturing Index will provide insight into how manufacturers fared in January. Hopes are high following last week's Chicago Business Barometer results. Exxon Mobil Corp. (NYSE: XOM) reports fourth-quarter 2009 earnings.
Tuesday: Motor vehicle sales for January will be reported and will provide a look at consumer spending following the holiday season. The Dow Chemical (NYSE: DOW), United Parcel Service Inc. (NYSE: UPS), and Kraft Foods Inc. (NYSE: KFT) report fourth-quarter results.
Wednesday: The ISM Non-Manufacturing Index will report on the health of the services sector. Cisco Systems Inc. (Nasdaq: CSCO) reports fourth-quarter results.
Thursday: Chain store sales for January, initial weekly jobless claims, and new factory orders are on the schedule for today.
Friday: The big January employment situation report will provide an update on the unemployment rate and the change in payrolls. Analysts expect no change in payrolls and a slight increase in the unemployment rate.
News and Related Story Links:
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- WJB Capital Group Inc:
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- Institutional Risk Analytics:
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- Capital Economics:
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