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Why the heck are the markets tanking?

·Markets Correspondent

The Dow Jones Industrial Average (^DJI) fell 537 points at one point on Friday before ending the day off 390. The first 10 trading days of the year saw a loss of over 1,400 points on the Dow, marking the worst two-week start to a year ever. Meanwhile, the broader S&P 500 (^GSPC) index is off almost 8% so far this year, and the Nasdaq (^IXIC) has dropped 10%. Europe’s Stoxx 600 Index (STXX) and China's Shanghai Composite Index (000001.SS) both entered bear market territory, down 20% off their highs. Thursday's rebound on Wall Street is proving to be short-lived, it seems, with significant downswings dominating trading to start the year, leaving investors scratching their heads and asking, “What the heck is going on?”

Ultimately the anxiety-ridden market -- which, is, by the way, impacting not just equities, but commodities, bonds and currencies, as well -- reflects investors’ concerns about global growth. Here are some of the main drivers affecting markets.

Oil, Oil, Oil

Today it costs under $30 to buy a barrel of oil—the lowest level in 12 years. What's behind this move?

Oil prices bounced around $100 per barrel from 2010 through most of 2014, benefiting mostly from increasing oil consumption in countries like China, along with conflicts in key oil-producing nations in the Middle East.

The selloff comes down to two simple Economy 101 forces: Increased supply and decreased demand. High prices prompted U.S. companies to start drilling for oil in shale formations using unconventional methods like hydraulic fracking and horizontal drilling.  This "American Oil Renaissance," which began to gain traction in 2010, has extended from the Eagle Ford in Texas to North Dakota’s Bakken Shale, Ohio’s Utica, and Pennsylvania’s Marcellus Shale.

To put it in perspective, the U.S. overtook Saudi Arabia and Russia as the top oil and gas producer last year. As prices slid, many waited to see whether the Organization of Petroleum Exporting Countries (OPEC)—a collection of oil-producing countries that pumps about 40% of the world’s oil—would cut back on production to push prices up. OPEC did nothing. Ever since Saudi Arabia’s decision to maintain output and defend its market share in late 2014—a decision it upheld at the end of 2015—prices have kept tumbling. And while U.S. drilling production has just started to decline, the decline has been far less significant than originally predicted. Meanwhile, additional oil supply from Iran could come any day now; Western sanctions on Iran over its nuclear program will soon be lifted, allowing the country to export its oil freely for the first time since 2012.

Then there's demand. Demand for oil globally has been tapering off, driven most notably by a slowdown in China’s economy. Until 2010, China had maintained an average growth rate of more than 10% annually for over 30 years. But as this robust growth has started to wane, with a current 7% target set out by Chinese authorities, investors have questioned how much further growth could slow in the second largest economy in the world.

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So why are low oil prices affecting the markets? Cheap oil means cheap gasoline. So shouldn’t that help consumer spending and the overall economy? Not necessarily. Here's why:

First, in the short term the fall in oil is damaging to risky asset prices, as oil and stocks are positively correlated from a markets perspective.

"We're in a risk-off environment where investors are trying to find safer investments," said Michael Hanson, Senior Global Economist at Bank of America Merrill Lynch.

Second, lower oil prices also cancel capital spending plans. Goldman Sachs has estimated that a decline in energy-related investment such as new drilling equipment has had more of an impact than consumer savings. And equities take an important cue from business spending, outweighing some of the positive effects on savings for the consumer.

Third, while only 6% of the S&P is directly exposed to energy, other sectors including materials and industrials are also seeing a significant impact from oil's fall. And, the more extreme negative impact on these groups has outweighed a more diffuse upside impact to some of the beneficiary sectors like consumer discretionary.

There seems to be a growing consensus that low oil prices have been a net negative for growth. In the 6 quarters since oil prices started to drop, U.S. GDP has averaged 2.3%, only a slight improvement over the 2.1% growth rate for the first five years of the recovery, as outlined in a recent note by Bank of America Merrill Lynch.


Stocks in the second-largest economy in the world have entered bear market territory for the second time in seven months. Why are U.S. investors interpreting China's woes as poison for the U.S.?

First off, China has been an important source of global growth with significant spending power. Being the second-largest economy in the world carries some weight.

Second, there is an important psychological effect in the markets from uncertainty surrounding China's economy, especially as China is a big purchaser of treasuries and a big force in global currency markets, according to Hanson.

In addition, a lack of clarity on the true health of the economy has added to the volatility. Investors don’t have a clear sense of just how strong—or weak—the underlying Chinese economy is. Investors are worried policy makers are struggling to revive the export-reliant economy. Meanwhile, the country is undergoing a shift from being manufacturing-oriented to service-driven, which has created its own strains. And a weaker yuan -- which would very well be much weaker without controls -- heightens worries that the slowdown in China's economy is deeper than official data suggests.

From a fundamental standpoint, the underlying economy may not be robust enough to hit the 7% target set by the government for 2016, already down from 10% growth reached over the last decade.

Meanwhile, just as China is devaluing the yuan, it has also been selling U.S. Treasuries to prop up its currency, which could put upward pressure on U.S. interest rates.

The dollar

Expectations for rising rates, with the Fed taking its foot of the monetary gas pedal, are putting upward pressure on the dollar. And when the dollar rises rapidly, the implications for earnings are significant. Over 30% of the revenues for S&P 500 companies come from outside of the U.S. and thus are negatively impacted by a rising dollar.

The U.S. manufacturing sector in particular has weakened due to a strengthening currency. "This shows up disproportionately in valuations in the major indices," according to Hanson.

Last week, the Institute for Supply Management (ISM) said its manufacturing index slipped to 48.2 last month, marking the lowest reading since the last month of the Great Recession. Readings below 50 reflect reflect contraction in the manufacturing sector.

Credit market question marks

In December, the high-yield bond market-- also known as the junk-bond market--which is comprised of riskier companies with high debt levels, was under pressure amid the oil slump, as worries abounded that companies in energy-related sectors would default on their debt. And the worries began to extend beyond the energy sector. The turmoil in the junk-bond market received heightened attention because it is seen as a leading indicator for the equity markets.

The junk-bond market stabilized toward the end of the month, but worries have continued surrounding the potential impact of defaults on the broader markets.

Uncertainty over the Fed

On Dec. 16, the Federal Reserve raised interest rates for the first time since 2006 and signaled four additional quarter-point rate increases throughout 2016. This move marked an end to a period of record-low rates that were designed to stimulate the U.S. economy in the wake of the great recession.

But while Fed Chair Janet Yellen emphasized during the Fed's December press conference that the committee will remain economic data dependent in its rate decisions going forward, many investors are concerned that our economy is not yet healthy enough for a continued rise in interest rates. While some data has continued to improve -- notably, the unemployment rate -- worries have abounded about continued pockets of mixed data, including Friday's disappointing retail sales, along with still-low inflation and global concerns that reflect a less healthy economy.

On Friday, New York Fed President William C. Dudley said he sees the U.S. economy continuing a strong growth trajectory this year, supporting further interest-rate increases.