The stock market has gotten off to a wobbly start in 2016. If this “correction” feels familiar to the one in August of last year, it is because the same reasons are still in play: the economic slowdown in China, fear of Fed rate increases, and the rapid decline in oil prices.
World Economic Growth
While economic growth in the U.S. remains fair to good, economies in other parts of the world are not doing so well. China, the world’s second largest economy, had been a strong engine of growth. It is now slowing dramatically. Europe is still struggling in the aftermath of the economic meltdown of 2008. Japan is also lagging. Emerging markets have suffered as the threat of Fed interest rate increases spurred investors to look for less risky places to put their money. The U.S. economy does not exist in a vacuum. Weakness in the rest of the world threatens to lead us toward recession.
The Price of Oil
Oil is one of many commodities seeing dramatic price declines. The price drop in oil has many ramifications. Emerging markets, mostly exporters of natural resources, such as oil, have felt the negative effects. They are not alone. U.S. companies that have invested heavily in new technologies to extract more oil from existing wells borrowed money through bond offerings. Plummeting oil prices now make these investments unprofitable and also make the interest payments on the debt challenging. Rising loan defaults have hurt high yield bond prices in the past year.
After much deliberation, the Fed finally raised rates in December with the expectation that this would continue, gradually, in 2016. This is beginning to look like a mistake. The dramatic declines in stocks could derail the Fed’s plans. In the context of global economic weakness, there is talk that the U.S. could fall into recession later this year.
The real fear behind all of this is the current low level of interest rates. One school of thought suggests that the Fed should have increased rates sooner, back to a more “normal” level near three percent. At just barely above zero (a quarter of a percent), the Fed lacks a major tool to combat recession.
When the dots of these three major interrelationships are connected – global economic slowdown, fear of Fed rate increases, and declining oil prices – we see how things could dovetail to become much worse. While predictions on the direction of stocks are of questionable value, many people believe (as do I) we are facing a rocky road in stocks. While the markets plummet, swoon, and crater, it is important to remember that they also rebound, skyrocket, and generally go up over the long run.