Engaging in fiscal or monetary stimulus measures is a gamble. The goals are always to boost economic activity, lower the cost of capital and encourage spending and investment. However, the X factor in this equation is sentiment. Will stimulus make investors and businesses more confident about business conditions, or does it indicate that the central authority is stressed and lacks confidence in the economy?
Traders bought the market on Monday in anticipation that the Chinese government would step in and try to stimulate its economy. Basic materials and commodity stocks were the primary beneficiaries of that optimism because investors expected that stimulus would increase demand for base metals and energy in the short term. However, by Tuesday, the story had changed.
The People’s Bank of China (PBOC) is attempting to offset dangerous setbacks in manufacturing activity by lowering the value of the Chinese currency, the yuan, relative to the dollar. Theoretically, this would make Chinese goods less expensive in dollar terms and could boost demand. The yuan floats in a tight range and, on Tuesday, the PBOC moved that channel down another 1.8%.
This is a pretty risky move that was then repeated on Wednesday.
Investors responded to this action negatively. There was no way for the PBOC to know that instead of inspiring optimism, the move to lower the value of the yuan revealed its lack of confidence and stress about the economy. This is the risk that a central bank takes when intervening in the financial markets. There is a fine line between stimulus and panic.
Just as commodity stocks were the primary beneficiaries of Monday’s speculation, they have been the target of sellers following Tuesday’s and Wednesday’s reality. As you can see in the chart of the Materials Select Sector SPDR Fund (XLB), a broad index of commodity stocks hit resistance on Monday’s rally and is now hovering near last month’s lows.
The move to the downside in commodity prices is a big problem for the broader economies of the U.S., China and Europe for a few reasons.
Lower commodity prices may keep inflation rates very low, which makes it more difficult for the Federal Reserve to raise rates in 2015. This may lower confidence even further and constrain consumption.
A lack of confidence for demand from China reduces corporate profits, which reduces business investment (already very low) and expectations for third-quarter GDP.
Slowing performance among commodity stocks in the energy sector will likely continue to hurt the high-yield bond market, which could spill over to other debt categories. This could slow the lending market and further dampen business investment.
There isn’t a lot about this week’s events that is likely to be seen as progress for China. Unfortunately, this increases uncertainty and could be the catalyst for a broader correction outside of the commodity markets. This isn’t the same thing as a bear market, but a long-overdue decline of 7%-10% could easily be led by a larger decline in commodity prices.
While the actions of the PBOC have increased uncertainty, the selling on Wednesday has been partially offset by a large decline in the U.S. dollar compared to the euro. Increased speculation that the Fed won’t be able to raise rates as quickly as traders previously assumed has weakened the dollar and could help support commodity prices in the very short term. It’s too early to say which factor will play a greater role, but we are inclined to assume that commodities will continue to decline in the short term, which puts the support levels on the S&P 500 and the other major indices at risk.
InvestorPlace advisers John Jagerson and S. Wade Hansen, both Chartered Market Technician (CMT) designees, are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next SlingShot Trader trade and get 1 free month today by clicking here. You can learn more about identifying price patterns — including bearish continuation patterns — and using them to project how far you think a stock is going to move in their Advanced Technical Analysis Program.