The Dow Jones Index (.DJI) and S&P 500 lost over 2% last week. On Wednesday, the volatility index (.VIX) spiked on a day when equities tumbled over 2%–if it weren’t for a slight uptick at the beginning of the week, stocks would be down much more for the week. What exactly is going on here?
Market Risk
The most obvious risk for some investors seemed to be systematic risk related to the American economy, but it’s not the kind of risk you’re thinking of. Some popular media outlets put the fall on Wednesday in the crudest terms as Wall Street’s disapproval of Barack Obama.
The truth is much more complex. Let’s first address the partisan bias: perhaps half of the professional institutional investors and fund managers on Wall Street are Democrat and the other half are Republican. In fact, political leaning often has little to do with market success. While it’s true that some high-profile financiers are staunchly Republican–Interactive Brokers and TD Ameritrade were established by men who have donated generously to the Republican party–three of the biggest donors to Obama’s 2008 campaign were Goldman Sachs (GS), JP Morgan Chase (JPM), and Citigroup ( C). UBS and Morgan Stanley were also top-20 contributors in 2008.
While it’s true that all of these banks became major contributors to Mitt Romney in 2012 (Goldman Sachs was Romney’s #1 contributor), this doesn’t mean that disappointment from an Obama victory would automatically result in a sell-off. The reality is much more complicated. Fund managers buy and sell when their models tell them to, and there was a much more compelling, albeit partly political, reason for Wednesday’s sell off. To understand that, you need to look at Congress.
The Fiscal Cliff
By far, the biggest concern that came out of the election is that no compromise will be made on the so-called fiscal cliff, a mix of tax hikes and budget cuts that would remove the budget deficit, but in the most painful way possible. This means higher unemployment, slower growth, and slimmer profits for companies. Investors are concerned about the massive job losses and economic contraction that would result from a failure to compromise. For most analysts, the problem lies in the Congress, where hardliners have dug in their heels and stopped a compromise from passing through, although many on both sides of the aisle are ready and eager to come to a bipartisan agreement.
The biggest worry from the election is that Obama and the Republican-led House will remain in deadlock. Little changed in the election, except for one thing: Obama won, and he won by a lot. Many political pundits are seeing this as a sign that the Republicans will need to compromise more, but Wall Street isn’t convinced quite yet. Hence the steep drop and persistent concerns about systemic risk due to political exposure.
Stagnant Wages and Slowing Demand
In the most recent issue of The Economist, an article exposed at considerable length the plight of the American poor. Regardless of your political view or attitude about social welfare networks, the facts outlined in the article are irrefutable: for the past 30 years, real incomes rose by 0.2%, while inflation has been around 3%. This means, in reality, people are making less money than they did in the past. When you factor in the much higher inflation rates for health insurance and education, the fact is that the consumer base in America has less discretionary income and less ability to stimulate the economy by opening their wallets.
This is another systemic risk that will drag down several sectors (technology, consumer-end, and automotive in particular), but a knock-off effect will mean lower margins and lower stock prices across the board. This remains a real concern for investors. Some entrepreneurs have looked for yields elsewhere, such as in subprime mortgages–and we all know how that ended. Another effort that plateaued in 2010 and began to decline in 2011 was aggressive expansion into China.
China Pains
“China expansion” for many sounds like a growth of factories and manufacturing in China, which has exploited cheap labor and ample natural resources to rapidly grow its economy mostly by producing goods at low cost. In the past 7 years or so, there’s been a more subtle but important expansion of American consumer-end retail chains in China, hoping to grab a slice of the ever-growing income of the rising Chinese middle class. Starbucks (SBUX), Yum Brands (YUM), and McDonalds (MCD) have been the most aggressive in this movement, followed by companies that have gone public more recently like Krispy Kreme Doughnuts (KKD) and Dunkin (DNKN). For these companies, China has remained a small portion of the revenue mix but an important growth driver as U.S. and Europe offerings either commoditize or market penetration reaches the saturation point.
However, China has seen its economy contract significantly relative to the double-digit GDP growth that Wall Street has grown to expect from the large, nominally Communist nation. The SPDR S&P China ETF is down over 27% over the past 5 years and has seen YTD growth of 10.72%–only marginally higher than SPY’s 10.43% growth in the same period. This suggests the run-away growth of Chinese equities is lagging due to a variety of systemic risks coming to pass. Wall Street is even more worried that the China growth story is over, and with no juggernaut to replace it, worries persist that companies cannot grow themselves by expanding into a large emerging market.
Conclusions
Next week, expect the market to debate with itself exactly how likely America is to avoid the fiscal cliff, and expect news of a compromise to cause stocks to rally. However, expect worries to persist over stubbornly high domestic inflation and the inability to expand into China to replace lost revenue at home. Next week isn’t a clear-cut bull or bear story when it comes to equities–but it really never is. Anyone who says otherwise is probably trying to sell you something.