Stocks slid again on Friday as various concerns still haunted investors. The pending timing of the Fed’s tapering of bond purchases, ongoing supply chain disruptions, continued spikes in the prices of key commodities, and the ongoing impact of the Delta variant all weighed on stock prices. Add in worries about the possibility of cascading defaults in China related to a possible failure of a large property developer and you have all the ingredients of a possible 5%+ correction, something we haven’t witnessed since the bear market that coincided with the start of the Covid-19 pandemic.
With so much negative sentiment built into market prices, the downside risk may be somewhat mitigated, especially considering the Fed continues to buy $120 billion of bonds every month. Indeed, should there be a correction of any significant magnitude (10% or more), the Fed could well defer any tapering process until markets stabilize. The Fed would like investors to believe that it is at least somewhat insensitive to markets, reacting instead to the fundamentals. But history shows the Fed is very attuned to markets. Any meaningful correction will defer the tapering process. Furthermore, once the process begins, any sustained rise in rates will quickly bring the process to a halt. To sustain growth, rates must stay low, very low. Like below 2.5% for the 10-year Treasury. Trickling up in that direction from the current 1.3% area is tolerable, but any quick rise, such as a 2%+ rate in just a few months, would not be tolerated. At best, the pace of tapering would slow. At worst, it would stop altogether.
In the opening paragraph I noted several causes of concern. Supply chain disruptions show little sign of disappearing. Ships waiting off key West Coast ports are waiting longer today than ever before. The Delta variant is still rising in areas like the Northeast. Natural gas, coal, aluminum, gasoline, and housing prices are at cycle highs and still rising. There may be legitimate reasons these increases will stop soon, but we heard the same reasoning two months ago, and prices keep rising. But perhaps the biggest rising concern is the possible collapse of Evergrande, the huge Chinese real estate developer. If you have ever been to China, you have seen a sea of construction cranes working on a series of 20-30 story high rise apartment buildings. This scene is repeated across every part of China. Many of these units are pre-sold to occupants who won’t even move in for several years. These buildings for years have been built on a sea of debt.
Now China’s government has decided to clamp down on rising debt as Evergrande keeps borrowing. It brings back images of our own real estate and mortgage crisis that began about 15 years ago and seeded the Great Recession. China may or may not be different. It is the same in that the current crisis was built on a sea of debt. It is the same in that the buyers, in many cases, are in over their heads. Remember, our crisis started initially with the collapse of sub-prime mortgage lenders. China today is similar, but what is potentially different is that we are a capitalist society and China is state operated. China, more than the U.S. government, decides, who survives and who dies. Evergrande doesn’t need to survive but the spread of the disease must be contained. Markets won’t be certain that China can halt the spread until, in fact, it does. Until then, debt markets could be roiled. Non-Chinese lenders to Evergrande stand to lose. While the epicenter of this meltdown is many thousands of miles away, the impact could be felt worldwide. In the late 1980s, currency crises throughout Southeast Asia sent markets reeling. A major hedge fund, Long Term Capital Management, collapsed. Those memories are being brought to life as investors watch what is going on in China.
While that is going on, the Fed keeps buying. Asset prices are a function of supply and demand. The Fed and central banks around the globe continue to buy bonds at a record pace. That has been the primary stimulus behind rising asset prices for months and it will continue to be until tapering begins. That is unlikely until November or later. If the Chinese debt crisis consumes world markets in the near-term, tapering will be delayed. The FOMC meeting this week is set to discuss the timing and pace of tapering. Actual details won’t likely be solidified until November. Any roadmap set this week will be written in pencil, not ink.
There are lots of lessons to be learned.
1. A lazy market without direction is a dangerous market if the macro news front turns sour. While the ultimate focus is on earnings and interest rates, disruptions in one market, such as Chinese debt, can spell over to all other major financial markets if not contained.
2. Debt can be wonderful, particularly if it is so cheap to service those costs in real terms are negative. But too much of anything is almost never a good thing.
3. Fixing big problems usually takes longer than anticipated. Current supply chain disruptions aren’t being cured as fast as anticipated just a few months ago. Too much demand isn’t the worst problem one might have, but it is a problem. Balanced supply and demand are much better, but suppliers can’t catch up if they can’t get enough supply themselves. It is a cascading problem likely to last well into next year.
4. With all this said, don’t lose sight of the big picture. Is the ballooning Chinese debt crisis likely to impact future earnings or interest rates, At the moment, the answer is most likely no unless China loses complete control of the situation. While that is possible, it certainly isn’t the most likely outcome currently. No doubt resolving it will be costly to both the Chinese economy and Evergrande’s lenders. It could even nick Chinese growth numbers. Will the average multinational company see a meaningful change in its long-term outlook? I don’t think so.
That doesn’t mean markets can’t or won’t correct in the near-term, even as the Fed keeps buying. In the very short run, $120 billion of new Fed money can be overwhelmed by emotional selling. A correction of 5-20% is certainly a possibility. Seasonality will have investors nervous. The Lehman/Fannie Mae/AIG collapse happened in September. The crash of 1929 happened in October. So did the one-day 22% drop in 1987.
Finally, there isn’t a whole lot of good news to look forward to for at least another couple of weeks. We will see more Q3 earnings warnings that are supply chain related. While the economy keeps chugging along, as we saw with Friday’s retail sales report, it isn’t accelerating. The Delta variant could fade but the impact won’t be meaningful for several more weeks. If there is any good news, it is that investors are already nervous and skeptical. Stocks have fallen 3%+ over the past several weeks.
We still believe any correction will be short-term in nature, and cathartic for markets that haven’t seen real buying opportunities for months. How big a correction is coming? No one really knows. China could take steps tomorrow that stop any correction before it takes place. Market timing is never easy and most often not very fruitful. I certainly wouldn’t be a hero and jump in on any one-day decline and I certainly wouldn’t panic and sell. Stay true to your asset allocation. If you are heavy in stocks because of the 2021 runup to date, taking some profits isn’t a bad idea. But, overall, stay calm. Whatever events are roiling markets today will pass quickly. The economic outlook for 2022 is excellent.
Today, Sophia Loren is 87.
James M. Meyer, CFA 610-260-2220