I don’t want to bury the lede, so I’ll start by saying, “I don’t know.” It could be, but I don’t think so. The bad Purchasing Managers’ Index reading out of China seemed to precede a market pullback everywhere except China, where stocks actually rose. Coincident with the bad reading—which only points to deceleration, not outright contraction—is a significant devaluation of the Argentinian peso, as the Argentine central bank is trying to conserve its foreign exchange reserves (which we warned about in our “Outlook 2014”). There’s also been a bad start to earnings season. Oh, and there’s probably nervousness about what the Federal Reserve (Fed) may—or may not—do when it meets next week.
All of these factors may have investors saying, just like Redd Foxx from the classic sitcom Sanford and Son, “This is the big one, Elizabeth!” as he clutched his chest.
Let’s put things into perspective. Valuations are higher than they were last year at this time. However, I don’t think they are anywhere close to bubble territory. Yes, you can look at average price/earnings based on things like the trailing 10-year earnings, but that’s never been a good market-timing measure. It also doesn’t account for major accounting rule changes that take place periodically, making past comparisons fuzzy, at best (for example, the change in accounting for goodwill in the early 2000s makes comparisons exceptionally difficult).
China is still growing at a fast clip, even with the slowdown. There are mounting concerns about the health of the banking system in China, and I think these concerns are justified. However, never underestimate the power of a deep-pocketed central bank to marshal resources to keep the financial pipes clear. To bet against China is to bet on policymakers making a colossal error. The same thing applies to the U.S. To bet that the Fed is going to tighten monetary policy too soon, or too much, is to bet on a major policy blunder. I’m not willing to make either of those bets. For the sake of social stability in China and based on precedence from the actions of the Fed, I think neither is going to muck things up too much.
For Argentina, there are echoes of the Latin American debt crisis of the 1980s and the Asian financial crisis in the late 1990s. Each was preceded by massive borrowing to fund economic growth, but most of that borrowing was in hard currencies like dollars. The problem arose when there was some shock—usually a dramatic change in commodity prices—that created inflationary problems and competitiveness issues. Growth slowed, currencies depreciated, and dollar-denominated debt became unserviceable. Thus, a crisis ensued with debt defaults and political instability.
Believe it or not, things are different now than they were then. Some countries in the emerging markets have debt problems, but most do not. It was also a problem that interest rates rose in the U.S., making it harder for indebted countries to refinance their loans at affordable rates. That’s hardly the case now. Exchange-rate regimes (the ways governments intervene in the currency market to affect the foreign exchange rate) are different now, as well. Some governments still intervene to suppress the value of their currencies relative to other currencies, but there is a lot more flexibility in exchange rates now than during the 1980s and 1990s when governments tried to peg their currencies, causing currency runs when official exchange reserves dwindled. There are problems now, but for a crisis you not only need a trigger, you need a propagation and amplification mechanism. More flexible exchange rates and lower indebtedness by many emerging markets countries have gotten rid of—or at least diminished—the risk of propagating and amplifying problems from one country to another.
While I could certainly be wrong, I don’t think the recent news out of China, Argentina, or corporate America warrant worrying much about a major move down in the markets.