United States

What the stock market decline means for the middle market

INSIGHT ARTICLE  | 

The 8.67 percent slide in the S&P 500 stock market index since the beginning of 2016 is the worst start to a trading year since 1897, which at that time coincided with the end of a four-year economic depression that began in 1893. This time around the financial dislocation has little to do with “free silver” or an unwise tariff placed on imports. Instead, it has to do with growing concern about the global economy, and particularly the economic conditions in China, and the interaction between U.S. dollar appreciation and the decline in the price of oil.

While financial conditions have visibly tightened on a global basis, for now there is little evidence of credit stress building in the plumbing of the global financial architecture or any sign that sources of finance for middle market firms are pulling back on lending. Jamie Dimon, CEO of JPMorgan Chase noted in an earnings call last week that the “middle market banking business is as good as it’s ever been.” Because most middle market firms rely on self-finance, the recent bout of financial volatility and turmoil shouldn’t decisively impact that market segment.

Middle Market Insight: While equity losses year-to-date are large by historical standards, at this point they don’t represent a financial and economic risk to the middle market or the segment of the real economy that has little exposure to foreign demand, oil, energy and commodities.

What’s causing global financial turmoil?

The dislocation in global financial markets is a function of three basic factors organized around faulty economic and financial assumptions about the direction of growth in China and oil prices.

First, the growth trend in China has noticeably slowed. Three decades of double digit per year growth has come to an end as the political, fiscal and monetary authorities attempt to rebalance the growth model away from one based on exports to one organized around domestic consumption.

Chinese authorities are trying to accomplish this while simultaneously attempting to deflate commercial real estate, residential real estate and an equity bubble, a Herculean task at best. While we anticipate that Chinese authorities will be successful in their long-run goal of rebalancing the economy, challenges in the near term require painful domestic choices involving global economic implications.

Among those challenges is that the commodity supercycle has come to an end. The benchmark Reuters-CRY core commodity index has declined by 48.3 percent since the slide in the price of oil began a year and half ago. This is indicative of the slowing in demand for commodities and raw materials used at earlier stages of production that underscored the boom in emerging markets during the past decade. Much of that demand was from China. With Chinese growth adjusting to a more sustainable long-term trend, this suggests a difficult period of transition ahead for many emerging market countries whose growth was tied to that demand.   

Given the slowdown in China’s growth, a devaluation of the yuan has become one the primary means of economic adjustment. Others will be organized around fiscal and monetary action. The non-deliverable forward market implies a further 6 percent depreciation in the value of the yuan during the next 12 months. Meanwhile, about 40 percent of S&P 500 company earnings are linked to the international economy, which is likely to slow below the 3 percent growth level that is used by many economists to define a global growth recession. Thus, it’s highly probable that losses in equity markets may worsen before they get better.

Second, during the past several years many investors and firm managers made the erroneous assumption that the price of oil would remain between $80-120 per barrel. This led to excessive risk taking in the oil, natural gas and mining sector and the issuance of high-yield debt to finance that speculation. The 72.6 percent decline in Brent crude has resulted in a drying up of capital for speculative purposes and a consolidation in the mining, oil and natural gas extraction industries.

The primary impact on middle market firms, however, is through the fixed business investment channel. Investment in the oil and energy complex has accounted for about two-thirds of the growth in private investment since the end of the Great Recession. The pullback that begin last year has resulted in a much slower pace of private investment and a loss of 250,000 jobs across the energy complex.

Third, the most recent leg down in oil prices that began in mid-December 2015 has as much to do with the 3 percent appreciation in the U.S. dollar as it does with the disequilibrium between supply and demand in global oil markets. It’s true that there are about 3 million too many barrels of oil produced per day in the global market, but that implies a price per barrel closer to $40 than $20. In the near-term, however, with the dollar likely to continue appreciating against many of its major trading partners, there is a strong probability that oil may trend down toward a $20 dollar floor before it stabilizes and reaches a more probable level at around $40 per barrel. 

U.S. equity markets

Using our preferred metric of equity market valuation (Tobin’s Q, an estimate of a firm’s assets in relations to market value) and cyclically-adjusted S&P 500 price-to-earnings ratio (a valuation measure that is defined as the price divided by the average of the 10-year moving average of earnings, adjusted for inflation) both the Dow Jones Industrial Averages and the S&P 500 index finished 2015 mildly overbought. Given the 8.64 percent decline since trading reopened January 4, a persuasive case can be made that each index is either fairly valued or slightly oversold.

What’s ahead?

At this point, apart from high-yield bonds and within energy, there is little evidence of broader contagion or credit risk, dollar funding stress or an impending banking crisis to force the Federal Reserve to resort to unorthodox credit easing measures to address the losses. Rather, the ball is in the court of the OPEC countries, which aren’t scheduled to meet until June. Meanwhile, decisions made by the fiscal and monetary authorities in Beijing will likely determine whether this is another tempest in a teapot or a global financial crisis unfolding in slow motion. 

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