Last Year's Headwinds Still Blowing

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Yesterday's trading was largely in response to negative developments in China, which fueled a global selloff. A few catalysts are responsible for the sour mood, but the primary focus is the latest reading on Chinese manufacturing.

The Caixin China manufacturing purchasing managers’ index came in at 48.2, the tenth consecutive contractionary reading. They noted that sub-indexes tracking production, new orders, and new export orders all declined.

This latest weakness comes even as the yuan continues to lose value against the dollar, highlighted by the WSJ chart below.

yuan dollar

Adding to the tension, a market-wide circuit breaker introduced by Chinese regulators yesterday was triggered twice. The first stoppage occurred once the index fell 5%, and lasted 15 minutes. Upon reopening, the index fell further and reached a 7% limit, which brought trading for the day to an end.

The fact that selling pressure was unable to be naturally exhausted on Monday has likely led to this morning's weak follow through, which could continue across global markets.

Investors are also apprehensive about the lifting of a six-month Chinese ban on selling shares, set to expire this Friday. The ban was imposed in July of last year and restricted selling by major shareholders, defined as those with ownership stakes greater than 5%.

Of course China isn’t the only bogey on the radar. Last year’s macro headwinds are still with us, including geopolitical tensions, a strong dollar, depressed oil and commodity prices, and the resulting flow-through to segments of the market such as junk bonds.

In the US, economic data continues to tell the story of a bifurcated economy, as manufacturing contracts while the service sector expands. In the chart below, readings below 50 signal contraction, while readings above 50 signal expansion.

manufacturing services

On Monday, the Institute for Supply Management’s (ISM) manufacturing index came in at 48.2, the second contractionary reading in a row, and the lowest reading since the end of the financial crisis. Manufacturing accounts for approximately 20% of the US economy.

The rout in US manufacturing began when the dollar took off during 2014. With major economies such as China continuing to guide their currencies lower, it’s unlikely the sickness here will be alleviated anytime soon.

On Wednesday, we’ll see the ISM’s latest reading on the service side of the economy, and Friday will bring us the important monthly jobs report.

From a technical perspective, the market continues to trade inside a downward sloping channel. The channel has been in place since the market recovered from last August’s swoon, which also had its roots in China concerns.

dow channel

The ongoing weakness here in the large-cap index continues to fit the pattern of a potential large rounded top. However, underlying strength in the service sector (80% of the economy) suggests that the deterioration in the economy (and consequently the stock market) may be muted or take longer to play out.

Also recall, as explained in a previous article, that while China plays an outsized and critical role in the overall economy, in terms of direct trade, China only accounts for 7% of total US exports, which is less than 1% of GDP. As far as corporate profits, US multinational companies derive only 2% of their net income from China. And with regard to banking exposure, China represents less than 1% of US banking system assets (according to Wells Fargo).

The New Year may bring a sense of refreshment and optimism, but the unfortunate reality is that none of the problems from our last trip around the sun have dissipated. The headwinds are still blowing, and so we must remain cautious and watchful.

The preceding content was an excerpt from Dow Theory Letters. To receive their daily updates and research, click here to subscribe.

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About Matthew Kerkhoff