The market selloff is worrying because there has been nothing but good news for the past couple of weeks. German, Japanese and US growth came in above expectations, inflation remains subdued, China seems able to grow and deleverage at the same time, North Korea has disappeared from the headlines, the Saudi Arabia regime change has proceeded quietly, and some form of tax cut in the US seems highly probable (Goldman Sachs analysts yesterday put the probability of passing a US tax cut at 80%).
If investors are selling now, it’s because all the good news has been figured into stock prices that are elevated (if not entirely bubbly) by historical standards. The drop in oil prices, cited as a factor in the global market selloff, should be good news: It reflects a narrowing of the risk premium attached to oil after the Saudi regime change. European political risk has diminished: Italy’s center-right appears to be resurgent against the populist coalition, and the Catalan independence movement will have little to say until the Dec. 21 elections. The biggest risk, in fact, is that Germany will fail to assemble a so-called “Jamaica Coalition” (Christian Democrats+Free Democrats+Greens) and will opt for another parliamentary election. The sharp rise in the euro suggests that this sort of risk isn’t foremost in investors’ minds.
The bogeyman of equity strategists, the eventual shrinkage of central bank balance sheets, doesn’t seem to have fazed bond markets, which rallied nicely during the past week. So what is ailing the world’s stock markets? This may be nothing more than profit-taking before year end, after a very profitable year. Of course, profit-taking can turn nasty in a market in which fund managers (according to a Bank of America calculation) have more risk and less cash than at any time in recent years.
There simply isn’t any reason for markets to crash. China’s financial problems are well in hand, Italy’s $2 trillion of debt is no short-term danger. And credit problems (for example, US retailers or subprime auto borrowers) remain isolated to particular sectors. Turkey is having problems but its $300 billion in foreign debt isn’t enough to tip over the system. And the earnings yield on global equities (see chart) remains very attractive relative to the aggregate yield available on world government bond markets as calculated by JP Morgan (see chart). But there still is a sense of malaise.
US corporate earnings can’t keep rising on the strength of consumer-based tech companies. German companies are running up against severe manpower and capital constraints. Japan’s labor force is shrinking and its trade-based spurt in GDP growth can’t continue at this pace for long. There’s no reason to expect a big downturn, but there’s less reason to expect the corporations that delivered steady profit growth during the past ten years to continue to do so. The growth engine of the major industrial nations’ market is getting strained. And that may be enough to motivate a significant market pullback–not a crash, but possibly a correction.