With the US stock market having recovered all of its losses following a tumultuous start to the year, traders and investors can take solace in the fact that things have seemingly improved. But have they really? With the market previously brought down by concerns over a slowdown in China, weak corporate earnings, and the uncertainty of the US Federal Reserve’s interest rates, one can see that these issues have yet to subside.
As China moves towards a services based economy, there are growing concerns around the debt levels that plague companies no longer benefitting from a commodity and manufacturing boom. What’s more, the country is looking at how such companies can endure – meaning there is a disturbing level of debt floating on the Chinese stock market, which is being propped up to avoid a repeat of the crash we saw last year. All the more concerning, an increase in credit is being used to finance government owned businesses, yet banks are recording a greater incidence of nonperforming loans. China’s plans, including corporate debt to equity swaps with banks and regional banking IPOs, aren’t attracting confidence either – prompting worries that there may be a spike in nonperforming loans, which could lead to defaults and bring down the US stock market through contagion.
In a previous article on corporate earnings, I noted that companies’ guidances had already been revised downwards several times – in fact, this trend has been occurring for some time, leading to low expectations amongst investors. With analysts predicting S&P 500 businesses to report profits that are 7.4% lower than they were a year ago, any failure to meet these targets could spell a renewed bout of pessimism amongst traders towards the economy, and drive the stock market significantly lower.
The other prominent concern that traders should remain mindful of, is the outlook for the Federal Reserve’s interest rates. Currently, traders are expecting the Federal Reserve to maintain rates at the upcoming meeting, while also winding back the speed at which they had originally planned to increase rates throughout 2016. History has shown that increasing interest rates inhibits the performance of the stock market (returns of 5.9% p.a. vs 15.2%), while volatility also tends to recede. To date, much of the turnaround in the stock market this year has been based on a dovish tone from Janet Yellen – meaning any change to this tone, or an unexpected rise in interest rates, could signal a major downtrend in the stock market.