The global markets were an absolute bloodbath on Monday, with last week’s weakness pushing hard into the start of the new week.
The Dow Jones Industrial Average fell more than 1,000 points at the open while the Nasdaq Composite dropped 9% as popular momentum stocks like Facebook Inc (NASDAQ:FB) rolled over. Apple Inc (NASDAQ:AAPL) helped stocks recover from the opening drop, helped in large part by an e-mail from CEO Tim Cook to CNBC’s Jim Cramer talking up its China business … but shares still ended off 2.5%.
In the end, the Dow Jones lost 3.6% to close below the 16,000 level, the S&P 500 lost 3.9%, the Nasdaq lost 3.8% and the Russell 2000 lost 3.9%.
The damage was hardly contained in the U.S. Japan’s Nikkei fell 4.6%. The Hang Seng fell 5.2%. Germany’s DAX was down 7% as it entered bear market territory. The dollar dropped hard while crude oil fell to a $37-a-barrel handle.
The CBOE Volatility Index (VIX), Wall Street’s fear gauge, is levels not seen since December 2008. That pushed the Credit Suisse AG – VelocityShares Daily 2x VIX Short Term ETN (NASDAQ:TVIX) recommended to Edge subscribers to a gain of 122% for the month, pushing their overall month-to-date gain to 83% on their holdings.
The immediate cause of Monday’s wipeout was a lack of action over the weekend by the People’s Bank of China to unveil fresh monetary policy easing in the form of an interest rate cut and/or a reserve ratio reduction. Action is being demanded as Chinese economic data worsens, stock market volatility continues despite aggressive efforts by Beijing to stop it, and everyone worries about the implications of a recent devaluation in the yuan.
Meanwhile, traders remained in fear with a potential September rate hike from the Federal Reserve still on the table.
The action reveals just how addicted markets have become on the flow of cheap money stimulus and the faith that it remains the path to economic deliverance.
The problem: Both are at risk.
A recent research paper from the St. Louis Federal Reserve Bank finds that after six years of quantitative easing that swelled the Fed’s balance sheet to $4.5 trillion, the policy “has been ineffective in increasing inflation” and only seems to have boosted stock prices.
What was once in the realm of tin foil conspiracy theorists is now being embraced by the Wall Street establishment. In a note to clients, Deutsche Bank analysts warned that “the fragility of this artificially manipulated financial system was exposed” and that “the only thing preventing another financial crisis has been extraordinary central bank liquidity and general interventions from the global authorities.”
They highlight “the genesis of this recent sell-off has been the threat of the Fed raising rates next month, but China’s confrontational move two weeks ago and the subsequent knock-on through (emerging markets) have accelerated us towards something more serious.”
As a result, they’ve dropped their odds of a September hike to 34% from 54%.
Over at Barclays Capital, economist Michael Gapen and Rob Martin have pushed back their rate hike forecast to March 2016. They admit Fed policymakers are “market dependent” and won’t tighten policy in the maw of a stock correction; even while they see “economic activity in the U.S. as solid and justifying modest rate hikes.” Should the market turmoil continues, the rate hike could be pushed past March.
Alberto Gallo, head of credit research at RBS, is more direct:
“Policymakers responded to the financial crisis with easy monetary policy and low interest rates. The critics — including us — argued against ‘solving a debt crisis with more debt’. Put differently, we said that QE was necessary, but not sufficient for a recovery. We are now coming to the moment of reckoning: central bankers look naked, and markets have nothing else to believe in.”
Now, contagion from China — lower commodity prices, lower demand, currency volatility — has revealed the structural vulnerabilities.
As for Fed hike timing, Gallo sees the odds of a September liftoff at just 30% — down from 36% last week — based on futures market pricing. December odds are at 60%.
The open question is: If the Fed delays its rate hike and the People’s Bank of China eases, will stocks actually rebound? Or has the Pavlovian reaction function been broken by a deeper loss of confidence?
We’re about to find out.
Keep two things in mind. Aggressive policy measures by Beijing over the last few months to stabilize Chinese shares have failed, perhaps unraveling the impression of bureaucratic omnipotence over markets.
And in the wake of the May 2010 “flash crash,” U.S. stocks initially rebounded before exceeding the panic lows in the months to come. The hit to sentiment from dramatics like today take a long time to heal.
On a final note, heading into the closing bell the Dow dripped back below the 16,000 level after Atlanta Fed President Dennis Lockhart reiterated that the Fed is likely to start raising interest rates this year, inflation is expected to rise, and that the jobs picture is set to improve.
It looks like the market needs to panic a little more to get a response from the Fed.
Anthony Mirhaydari is founder of the Edge and Edge Pro investment advisory newsletters. Two- and four-week free trial offers have been extended to InvestorPlace readers.
