Chinese equity market meltdown doesn't matter much

Outlook:

Today we get durables, which feeds GDP (Thursday). This will be our first taste of Q2 GDP and will be accompanied by revisions to that awful Q1. The consensus forecast for Q2 is 2.7%. The BEA will introduce new seasonality adjustments that might take away the first quarter curse, plus we will get a reprise of GDP vs. GDI, or gross domestic income. The two should be the same but GDI is advancing faster and higher, suggesting we are measuring something wrong, probably productivity. Expect the first part of the week to be chock-full of speculation about GDP, but probably the take-away is that the recession really is over, even if growth is not as high as other postrecession recoveries, and it’s time for the Fed to get moving.

Wednesday at 2 pm is probably a critical time. That’s when we get the Fed statement and while most observers think we won’t get a clue, the absence of a denial is the clue itself. The Fed would have to lean over backwards to justify not raising rates. That still doesn’t necessarily mean September, but it sure doesn’t mean 2016, either. Yellen wants to be non-committal about the exact timing but not about the Event.

The kerfuffle over the unintended release of staffers’ projections doesn’t tell us much, either, although the staffers see a single rate hike this year. The leak story is gathering steam not only because the staffers are far more pessimistic than we knew, but also because leaks from the Fed are as rare as hen’s teeth. The staffers see growth falling from 2.41% in 2016 to 1.73% in 2017 when the official forecast is for an ongoing rise to 2-2.30%. Inflation will be lower than the official forecast and the Fed funds rate will be 0.35% in Q4, rising to 1.26% in 2016 and 2.12% by Q4 2017. As the WSJ reports, “policy makers on the committee saw a higher median fed-funds rate of 0.625% at the end of this year, rising to 1.625% in 2016 and 2.875% in 2017.”

We say the staffers’ projections don’t matter much—these folks may be top-notch economists but nobody can predict something as big and complex as the US economy.

Something else that doesn’t matter much is the Chinese equity meltdown—again. China may be big and powerful, but it lacks a retail base and fund managers experienced in price variations, never mind a true rout.

To be fair, traders in advanced markets behave like hysterical schoolgirls, too. Mostly in the US we don’t like government interfering in markets, although we have circuit-breakers and short-selling rules (sometimes) and other measures. But these pale in comparison to the measures China has taken, which everyone (and we do mean everyone) saw as excessive and just plain wrong. It will be interesting to see what happens this time, but not particularly instructive as to what comes next for US equities. We have earnings reports that are some degree more trustworthy than the accountings offered elsewhere. They may be inaccurate to a large degree, but not entirely fabricated. We will get scandals again, to be sure, but this time we have no reason to believe an Enron or Worldcom is lurking in the shrubbery. The real problem is not a loss of confidence in the equity “system” as we are seeing in China, but rather that the prolonged lack of any alternative has savers and investors overweight equities. If gold is falling out of favor at least in part because it carries no yield, why would equities in a similar boat (no dividend) not also fall?

Doom-and-gloom types have been saying for a long time that we will get a stock market rout when the Fed finally does move to raise rates. But as we wrote last week, history doesn’t bear out the thesis, not that you can really count on history when the sample size is one or two data points. But in 2004 when the Fed raised rates, we got a 3% drop in the first month and then a lasting rally. If the Fed were to stay its hand out of fear of a bad stock market reaction, we would be very surprised. It would be inconsistent with everything Volcker and Greenspan taught us to believe about the Fed—the Fed may be annoying, but it’s not cowardly.

The one Chinese market rout fallout we might expect is a general rise in risk aversion, and that tends to be favorable for US assets and the dollar. But don’t count on it just yet. We need to hear the reasons, if there are any, for the surprise euro rally Sunday night. What are these traders thinking? Or perhaps they are just putting on the short squeeze to the weak hands, and let’s face it, retail traders are the weak hands. Given all the talk about the euro failing in key ways, we can hardly point to “sentiment” favoring the euro. Alas, that doesn’t mean it will fall.

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