The REAL Threat to the Markets This Summer

by Daniel Putnam | June 12, 2013 8:55 am

Since the 2008 financial crisis, a quiet battle has been waged in the world economy.

On one side are the deflationary forces of deleveraging and slow growth; on the other are the inflationary policies of the world’s central banks. So far, the central banks have been winning, with their low-rate and quantitative easing policies offsetting the forces of weak economic conditions worldwide. In the past month, however, the markets are signaling that a change might be at hand — specifically, that slowing growth in China has begun to overwhelm the efforts of the world’s central banks.

The key question now is: How long the U.S. stock market can hold out?

A look across the global financial-market landscape reveals some crucial developments in the past month:

divergence The REAL Threat to the Markets This Summer[9]

Alone, none of these events would be particularly alarming. But together, they paint an uglier picture about what’s going on in China.

While the headline economic data isn’t particularly frightening just yet, most investors don’t put much credence on China’s official numbers. The true measure of what’s taking place in China — financial-market performance — is starting to show that the possibility of a “hard landing” is still very much on the table.

That these China-sensitive investments would be displaying this much weakness right now — a time of unprecedented central bank support globally — is telling. Despite their best efforts, central banks are failing at their efforts to reflate the global economy.

This is borne out by developments here in the U.S. bond market. Since March, the Treasury Inflation-Protected Securities breakeven rate (the 10-year Treasury yield minus the 10-year TIPS yield, a measure of inflation expectations) has collapsed from 2.59% to 2.1%[10]. This is a clear signal that the forces of deflation are winning the battle at the moment.

To be clear, this isn’t a bearish trading call on the asset categories above. In fact, many of these market segments are deeply oversold and quite possibly on the verge of a short-term bounce.

Instead, the downturn in these sectors is a warning signal that China represents the black swan that could send stocks on a rougher ride[11] as we move through the summer.

The counter-argument to this assertion is that mining and emerging markets have been weak for months, but the U.S. market nonetheless has continued to move higher. Further, the fuel for the rally has come from sectors whose fortunes aren’t dependent on China: healthcare, financials, retailers, large-cap tech[12] and certain industrials.

True enough, but it’s also naïve to think that even these leadership groups will remain immune from protracted trouble overseas. If the selloff in the global markets continues, these sectors will become ripe for profit-taking as investors seek to raise cash — something that already has become apparent in the sudden weakness among defensive, low-volatility areas such as utilities[13] and consumer staples.

Simply put, something has to give.

Investors should therefore keep a close eye on the aforementioned China-sensitive assets in the days and weeks ahead. Although the broader averages have been holding fairly well, the deflationary forces emanating from China might soon prove too strong for this aging bull market to withstand.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.

Endnotes:
  1. EEM: http://studio-5.financialcontent.com/investplace/quote?Symbol=EEM
  2. ILF: http://studio-5.financialcontent.com/investplace/quote?Symbol=ILF
  3. EWZ: http://studio-5.financialcontent.com/investplace/quote?Symbol=EWZ
  4. FXA: http://studio-5.financialcontent.com/investplace/quote?Symbol=FXA
  5. KOL: http://studio-5.financialcontent.com/investplace/quote?Symbol=KOL
  6. SLX: http://studio-5.financialcontent.com/investplace/quote?Symbol=SLX
  7. BHP: http://studio-5.financialcontent.com/investplace/quote?Symbol=BHP
  8. VALE: http://studio-5.financialcontent.com/investplace/quote?Symbol=VALE
  9. [Image]: http://investorplace.com/wp-content/uploads/2013/06/divergence.gif
  10. collapsed from 2.59% to 2.1%: http://bonds.about.com/b/2013/06/11/why-the-yields-on-10-year-tips-have-turned-positive.htm
  11. a rougher ride: http://investorplace.com/2013/06/stocks-are-approaching-a-key-inflection-point-whats-next/
  12. large-cap tech: http://investorplace.com/2013/06/large-cap-tech-stocks-the-new-defensives/
  13. utilities: http://investorplace.com/2013/05/dont-expect-utilities-to-stay-defensive-during-a-downturn/

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