The Daily Difference: New Year, Renewed Volatility

New Year, Renewed Volatility Equity markets have started 2016 in in a foul mood. As of this writing, the Dow Jones Industrial Average has fallen roughly 700 points, or 4%, in 2016. What is behind the volatility? We see two main drivers behind the market movements so far this year: China and oil.

Political Interference in China Does It Again

Earlier this week, China attempted to limit volatility and downward movements in their equity markets by imposing “circuit breakers” that will temporarily halt trading after a 7% drop. This has created the complete opposite of the intended outcome. Market volatility of this magnitude in Chinese markets is nothing new, and when a regulatory agency restricts access to capital and free decision making, fear and desire for capital can take over and exaggerate market moves. This morning, China suspended their “circuit breaker” rule after less than a week to allow more normalized trading, which we view as positive.

Another likely catalyst for the volatility in China is the pending expiration of a 6-month ban on selling by major shareholders of Chinese corporations. This ban is scheduled to be lifted on January 8th, which likely caused a rush to sell ahead of the major shareholders. Chinese regulators are expected to extend this ban.

The final major contributor to the recent volatility in China stems from the move last Thursday by The People’s Bank of China to reduce the reference rate (peg rate) of the Yuan by 0.51% to 6.56, the weakest since 2011. This move was reminiscent of a similar move in August that sparked fears about a slowdown in China.

Crude Oil

Crude Oil has continued its decline during the first few days of 2016, falling approximately 10% to $33.14 earlier this morning, which is the lowest level since December of 2003. What has caused the further acceleration to the downside in oil prices?

Supply issues are nothing new, but we really have not seen any meaningful improvement in the supply equation. Last week the EIA (Energy Information Administration) reported a 5.1 million-barrel fall in crude supply, but this was overshadowed by data showing the largest surge in gasoline supplies since 1993.

Further concerns about a slowdown in the Chinese economy and how that might impact the demand for commodities from the world’s largest commodity consumer has contributed to crude’s selloff in 2016, especially in light of the other issues discussed above. Oil prices have ignored geopolitical events coming out of North Korea, Saudi-Arabia, and Iran that would usually drive oil prices higher, as the significant supply imbalances are acting as a cushion against potential supply disruptions.

Should we be making any moves within portfolios now?

When volatility enters the equity markets, we first look to the bond markets to tell us the real story. We are looking closely to see if prices are moving higher and to what magnitude, which can signal a flight to quality, potentially from selling in the equity markets. As we write this, bond markets are actually selling off in price, an indicator to us that panic in the equity markets is not translating to the bond markets. Why do we look at bond markets? The U.S. bond market is substantially larger at roughly $40 trillion in size than the U.S. equity market at $26 trillion, and is generally viewed as a more accurate indicator of risk in the markets. At this point, the bond markets are not signaling panic and fear, or a further leg down; they are quite calm and flat.  This gives us reason to believe that this volatility is likely to be short-lived, or at least contained. Furthermore, it is not all bad news. We continue to see reasons for optimism, particularly from U.S. economic numbers. For example:

  • Corporate earnings are estimated to grow by 2.5% this year – not overly exciting, but a solid growth number
  • Employers have been creating, on average, 220,000 new jobs per month for the past year
  • Layoffs are at extremely low levels
  • Car sales are very strong and at record levels
  • Housing has recovered, prices are increasing and mortgage rates are accommodative
  • Household net worth is close to record levels

That being said, the oil market needs to stabilize for the markets to move higher. We are not making any allocation changes at this point, and will look to put money to work selectively if and when oil stabilizes.