Another Roller-Coaster Year for Equities?
The phrase "May you live in interesting times" may not be an actual Chinese curse, but given the recent Chinese economic news, it seems appropriate to apply it as one. If the first trading week of the New Year is to be indicative of the rest of the year, we are in for a wild ride in 2016.
Most of the week's economic action focused on the chaos in the Chinese markets as a "circuit breaker" designed to stop large drops in market value not only failed but also added to the decline. Market losses propagated throughout the world as China's Central Bank struggled to regain control. At one point, approximately $2.5 trillion in global equity value had been wiped off the books in just four days of trading. Chinese trading days were defined in minutes instead of hours.
Good news cleared the economic storm clouds by week's end. The Chinese government scrapped their circuit breaker and allowed the markets to flow more naturally. Meanwhile, the Chinese Central bank raised the midpoint for the Yuan's trading on Friday, ending an eight-day run of lower midpoints. Traders were concerned that the Chinese government may have been acting intentionally to devalue the currency and potentially spark a currency war.
The brightest spot came in the form of the US jobs report. According to the Bureau of Labor Statistics (BLS), 290,000 jobs were added in December 2015. Combined with a sharp upward revision of 50,000 jobs over October and November, the December report brings the 2015 jobs total to 2.65 million jobs added — not quite up to the over 3.1 million jobs added in 2014 but still a solid gain.
Markets responded positively to the collective Friday news. Does this news suggest overall good or bad times in 2016? Neither one — it just suggests greater market volatility moving forward.
Strong Job Growth, But Is It Sustainable?
Overall, the December jobs report is filled with good news. An aggregate 340,000 increase in jobs kept the unemployment rate at 5.0% for the third straight month. Construction posted 45,000 new jobs for a third straight month of gains, the professional and business services sector added 73,000 jobs, and health care and food services added 39,000 and 37,000 jobs respectively. Things look relatively promising everywhere but the mining sector, which lost 129,000 jobs over 2015 thanks to the current oil glut.
The only significant blemish was a slight decrease in average wages, dropping one cent to $25.24 per hour. For the year, average wages rose by only 2.5% — but in the context of near-zero inflation, that is a tangible gain in purchasing power.
Stubbornly low wages and zero inflation in the face of job growth are leading some economists to rethink what full employment means. At the end of 2007, prior to the Great Recession, the unemployment rate matched today's 5.0%. However, the employment-to-population ratio was 63% then compared to 59.5% now. Baby-boomer retirement cannot account for the entire differential, thus there are still a significant number of people on the employment sidelines. Can these sidelined people be brought back into the workforce, and can wages rise until they are brought back?
Neil Irwin of The New York Times notes that with the current labor force and the current rate of job growth, we would hit 3.8% unemployment sometime in September 2016, the lowest number in modern times. As Irwin puts it, "Something has to give." Either new workers will be drawn back into the workforce or job growth has to slow by definition. There will likely be a balance between the two forces, and that balance will define what happens to wages and inflationary pressures.
Circuit Breakers and the Magnet Effect
On the other side of the world, the Chinese government is dealing with their own balancing act with an obviously slowing economy and a stock market that is lacking in confidence. Their circuit breaker is designed to kick in at a relatively early stage — a 5% drop (or gain) for the day halts trading for 15 minutes while a 7% drop halts it for the day. For comparison, S&P 500 circuit breakers occur at the 7%, 13%, and 20% thresholds.
With circuit breakers earlier and closer together, a "magnet effect" is created that worsens the problem. When the threshold is approached (around 4% in China), traders change strategy to sell assuming 5% will be reached, producing an effect similar to the increased pull of a magnet on a metal object as the two approach each other. Instead of calming a market, the circuit breakers lock in continued selling. Traders rush to be the first to sell so they are not left holding the bag when trading is halted for the day.
As a result, we get trading days that last 14 minutes and heightened anxieties about what will happen on the next day, exacerbated by the government's decision on where to place the Yuan's midpoint. Chinese markets hate uncertainty as much as US markets do, and when traders and economists are forced to guess on the true state of the economy, they tend to stay conservative and assume the worst.
Companies with large bets on the Chinese market and/or ones that have a large manufacturing presence in China are suffering the most. Apple (NASDAQ: AAPL) has taken one of the largest hits, with a drop in over 15% in the stock price in one month (as of this writing) and a drop in market cap of over $115 billion.
If these global trends continue, the slow yet steady growth of the US economy should offset some of the concerns about the Chinese economy, which is clearly going through a period of downward adjustment. Given the lack of transparency in the Chinese Central Bank and stock markets (overlaid with occasionally baffling strategy), the uncertainties can amplify the effect on stocks beyond what they really should be.
As in the US, the Chinese stock market and the Chinese economy are two different things. The stock market is only a reflection of that economy, and it is a distorted one because of the peculiar Chinese rules. Concepts like the Chinese circuit breaker must take the proper psychology into effect, and the government's lack of experience with an increasingly free economy leads to missteps. Keep that in mind when drawing long-term inferences about China's actions.
At home, it would not be a surprise to see a downward adjustment in jobs reports in the early part of 2016 thanks to seasonal factors and other adjustments. Recall that November and December 2014 brought us 752,000 new jobs, while only 773,000 jobs were created in the first four months of 2015. Yet we recovered to keep relatively steady job gains through the whole of 2015.
In short, 2016 will almost certainly continue to be a volatile year, but don't let volatility shake your overall plan. Panic selling kills retirement dreams just as easily as market losses, and maybe even more so. We suggest treating your portfolio like the Fed is treating interest rates — make your changes incremental and infrequent.