Why the stock market is tanking right now, and what comes next

It’s been one of the worst starts to the year ever for the world’s stock markets. All the more reason to keep your nerve

Look around the global market place and you’d be hard pressed to find anywhere in the green. Out of hundreds of major global indices fewer than 20 are positive; you have to look to Slovakia (up 5% year to date) to find one of the few bright spots.

Everywhere else, it’s red—blood red, if you ask anyone owning equities. Today alone, the S&P/TSX Composite at one point was down 4%, although it’s since eased back and finished the day down 1.33%. And it’s not just Canada that’s feeling the pain. The benchmark U.S. indices, likewise, aren’t far behind, with the Dow Jones Industrial Average down 1.56% and the broader S&P 500 down 1.17%.

Such single day losses are always tough to swallow, but these drops come after an almost continuous stream of losses since the start of the year, with barely a whiff of a positive market response to act as a buffer. It’s been like this since the opening bell on January 2, the first day of trading for the year. It’s as if the market turned the page on 2015 and entered an entirely new reality.

It’s not, of course. Here is what need to know about the selloff and what it’s going to take to stop it:

The source of the instability

According to Jurrien Timmer, Fidelity Investments’ director of global macro strategy, there is a major policy divergence between the US and China. On the one hand, the U.S. central bank is in moving into tightening mode, while on the other is China’s central bank is devaluing its currency as that country deals with a growth recession (despite the positive GDP number they are reporting publicly). By some accounts, China’s currency is overvalued by as much as 15 to 20%.

“When the world’s second-largest economy is tied to the largest economy and they are on different paths, it creates tensions,” he says. While this pain may feel more acute now, this is really just a continuation of what has been going on for six to nine months. The seeds of this selloff were planted back in August: at the time, China’s central bank suddenly devalued its currency as a sort of shot across the bow of the U.S. Federal Reserve when it was preparing to start tightening interest rates. The Fed blinked, says Timmer, but only briefly, as the U.S. central bank went ahead with a rate hike in December.

For the past six years investors have grown addicted to easy money with the help of Quantitative Easing policies, but now that those polices have ended we’re seeing the other side of it. “It’s like a patent going through withdrawal,” says Timmer. While he isn’t convinced we’re seeing a repeat of the market dive we endured in 2008, he says this is still serious liquidity event.

Coming into 2016 China’s central bank certainly didn’t help matters, says Paul Taylor, Senior Vice President and Chief Investment Officer for BMO Asset Management. The central bank introduced circuit breakers that were designed to stave off panic selling, but instead made things worse.

Slipping on oil

Oil prices are at US$26.76, their lowest point since 2003. (When adjusted for inflation that figure would be closer to US$11.23.) If you’re a Canadian producer it gets worse still: Western Canadian Select puts the cost of a barrel of crude from Canada at US$14.50 today.

In many ways, the steep selloff of oil is linked to the divergence between the U.S. and Chinese economies. China is no longer growing at 7 to 10%, which means less demand for commodities, explains Timmer.

There is another factor here too and that’s Saudi Arabia. In the past the Saudi’s would cut output to keep prices high, but with Chinese demand weakening the Saudi’s are using this as an opportunity to put non-conventional high cost producers out of business, says Timmer. It’s working. Producers in Canada and the U.S. aren’t making any money resulting in projects getting shut down and companies defaulting on their loans.

This could create an opportunity for investors. “The decline in oil is unsustainable,” says Timmer. “The more stress. The more projects will get shut, but that means oil is going to rocket back because there won’t be enough supply.” While much has been made about the lifting of sanctions against Iran oil and how it will only dump more oil onto a market that’s oversupplied, Timmer feels that’s already been priced in.

Return of the “Canadian peso”

The selloff of the Canadian dollar has been particularly abrupt. In October of last year, the loonie was trading at 77 cents to the U.S. dollar; today it’s worth a dime less. Given how important oil has been to the Canadian economy in recent years it shouldn’t come as a huge shock that the loonie is heavily correlated with the decline in the price of oil.

Although there seems to be no end in sight, investors like BMO are less keen on betting against the loonie today than they were a year ago. According to Taylor, all last year BMO was running a $1.2 billion short against the Canadian dollar versus the U.S. greenback. “We made $120-million off that hedge, but we’re off that hedge now” he says. Taylor believes oil will be higher at then end of 2016 than where it is right now and that will lift the loonie as well.

What’s next

What’s next? For starters, a rate-hike in March by the U.S. Fed is completely off the table, says Timmer, who expects the central bank will also signal that it intends to hold at this level for some time. That will take some pressure off the Chinese yuan, which should help stabilize that market.

For investors this could be a good thing, particularly for those who are light on equities in their portfolio. Timmer thinks we could see a “V” shaped market recovery like 2009, with a sharp bounce back for those parts of the market that have been particularly beaten down.

Taylor agrees, adding he expects to see institutional investors to start getting back into the market. “If we get through this two, three, four weeks without things coming unglued then we are going to see some of the people like ourselves stepping in to take advantage of this downside volatility.”

As rocky a start as we’ve had to 2016, investors need to remember we are only two and half weeks into the New Year. “The first thing investors should do is chill and not be overly concerned by what we are seeing,” says Taylor. Since the financial crisis the market really hasn’t experience a typical correction. “Emotionally, investors are just unprepared for the volatility,” he says.

“We think we are reaching the point of capitulation. Coming at it from the buy side… this is a time to pick away here.”