Independent Thinking^®

John Apruzzese: The United States and the Global Economic Slowdown

Behind the grim financial headlines of the past few weeks are a few reasons for the 7.5% drop in the S&P 500 since its high on September 18. While it’s too soon to tell if this is the start of something bigger, these market drivers remind us that the United States is not immune to the global slowdown. There are also several extraneous factors that, while unsettling, have no real impact on this economy.

This does look, at least in part, like a correction. The S&P rose almost 50% in two years with abnormally low volatility. While it was easy for investors to become accustomed to this state of affairs, it’s important to keep in mind that it was exceptional — and that the stock market almost always falls faster than it rises. The Federal Reserve has done the market no favors in mishandling its communications lately, and investors are understandably confused about the timing and scope of interest rate rises.
 
There’s more at play here than a simple correction, though. The Chinese economy, now equal to that of the United States in purchase-power parity terms, is a bigger and potentially more troubling issue. After 35 years of double-digit growth, China’s economy is grinding down and could even turn into a full-blown debt contraction/deflationary cycle. China is now about a year into declining real estate values and its inflation rate has recently dropped below 2%. Its debt overhang arguably exceeds the subprime mortgage excesses in the United States, which triggered the global financial crisis of 2008-2009.
 
The slowdown in China should get more press. The innumerable benefits that western economies and companies have received from China’s unprecedented expansion are often taken for granted by investors, as are the ramifications of its growth rate on other economies. Commodity and oil prices, the proverbial canaries in the coal mine of global growth, have dropped precipitously this year as demand from China eases and may continue to fall.
 
It’s important to note, however, that the negative effects of a hard landing in China will be limited to trade and will not directly impact western financial institutions. The country’s central authorities have done well to date but certainly have their work cut out for them now. The complexity and size of the economy will make managing a downturn extremely challenging.
 
Ill winds from Europe are also impacting markets here. Pressure from Germany to avoid a U.S.-style quantitative easing has increased risk that European Central Bank President Mario Draghi will not deliver on his July 2012 promise to do “whatever it takes” to preserve the currency union. Europe has also been slow to deleverage its banking system and to reform labor laws and other impediments to employment. Economic data in the region now points to zero inflation and negative economic growth.
 
Other headline items should have little or no real influence on investors, however. Unfolding events in the Ukraine, new and old dramas in the Middle East and, most recently, the Ebola scare in the United States, are troubling in political and human terms but are not impacting economic fundamentals.
 
Lost behind the headlines are the continuing improvements in the U.S. economy and the associated benefits of lower energy prices and interest rates. Corporate earnings for this quarter are likely to be robust, as they were three months ago. But the United States is not, with apologies to John Donne, an island. Indeed, it is a smaller part of the global economy than it was prior to the rise of China and other emerging markets (16.5% of the global GDP, down from 26% in 1980) — and more interconnected than ever.
 
Corporate guidance over the next few weeks will be telling, as will further communications from the Fed. In the interim, we are advising clients to adhere to their long-term asset allocation strategies and to take care in distinguishing meaningful market developments from distractions.
 
John Apruzzese is the Chief Investment Officer at Evercore Wealth Management.