U.S. Stocks Battle Global Slowdown

October 16th, 2014
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Investing Daily Article of the Week

by Philip Springer, Investing Daily

The world stock market gyrated wildly this week. The big down days, Tuesday and Thursday, were triggered by rising anxiety about global growth, particularly in Europe.

Wednesday’s upside reversal, the best day for U.S. stocks so far this year, came with signs that the Federal Reserve may not start to raise interest rates as soon as some expected.

Follow up:

After a summer of impressively low volatility, Thursday marked the 12th trading session of the last 18 in which the Dow Jones Industrial Average had a triple-digit change. It’s the most volatile stretch for U.S. stocks since 2011.

The bad news from Europe came mostly from Germany, the region’s largest economy. Two key measures in August suffered their biggest monthly declines since 2009: Industrial production fell 4% and exports plunged 5.8%.

The 18-nation euro zone currently is struggling to avoid falling into its third recession since the financial crisis, with its three biggest economies (Germany, France and Italy) leading the way. The risk of deflation also is increasing, with inflation currently running at a miniscule 0.3% annual rate. This is far below the European Central Bank’s target rate of 1.95%.

Adding to the negative tone, the International Monetary Fund on Tuesday cut its forecast for growth in the 18-nation euro zone this year yet again, to just 0.8%. The IMF also downgraded its outlook for global economic growth again, citing persistent weakness in the euro zone and a broad slowdown in several major emerging markets. The IMF expects the global economy to grow just 3.3% this year. Growth of 3.8% is expected next year, down from the July forecast of 4%.

But the IMF also raised its U.S. growth estimates for the U.S., from 0.5% to 2.2% for 2014, rising to 3.1% in 2015. This makes the U.S. a star among the world’s developed-market economies. But a major uncertainty is whether slowdowns in other major economies will spill over to the United States.

European stocks started to weaken in June. Most measures of stock-market breadth here topped out in July, but the popular large-company stock measures, the S&P 500 and the Dow industrials, hit new all-time highs last month before faltering.

Here in the U.S., defensive stocks have held up relatively well: utilities, consumer staples and health care. More than 60% of each sector’s stocks are still trading above their 50-day moving averages. On the negative side, energy has been by far the weakest sector, followed by telecom, materials and technology among the Standard & Poor’s 500′s 10 sectors.

Energy stocks have suffered from a recent sharp decline in oil prices, due to oversupply and reduced demand because of the weakening global economy. Another negative has been the strong dollar, which effectively increases the cost of oil and other commodities for global buyers.

Shares of U.S. small companies also have come under pressure. The benchmark Russell 2000 index now is down 10% this year, while the large-company Standard & Poor’s 500 is up 4%.

In theory, a stronger dollar should be good for smaller-cap stocks. Reason: Their businesses are primarily based on domestic revenue. In contrast, large multinational companies generate much of their revenues from abroad, so they suffer from adverse currency translations as the greenback strengthens. But a stronger dollar actually has become more closely correlated with “risk-off” investor behavior since the financial crisis.

The U.S. Dollar Index, which measures the greenback’s strength against the euro, yen and other currencies, gained 7.7% during this year’s third quarter. This was the buck’s bigger quarterly gain since 1992, aside from the third quarter of 2008, when investors fled to its safety during the global financial system’s meltdown.

The dollar is rising for several reasons. One is the relatively strong U.S. economy. And the Federal Reserve has almost ended its quantitative-easing, bond-buying program, marking a gradual move toward a tighter (but still easy) monetary policy. In contrast, Europe and Japan are fully engaged in their own developing or fully developed QE2 programs, which effectively lower rates and currency values.

Also, U.S. Treasury securities pay significantly higher yields than those of other major government bonds. With 10-year Treasury issues currently paying 2.3% in the U.S., other government 10-year yields range from 0.5% (Japan) to 0.9% (Germany) to 2.2% (United Kingdom).

The greenback’s strength has pros and cons. A rising currency dampens inflation and lowers the cost of imports. And it reduces what we pay for many commodities, which typically are priced in dollars.

But the better dollar is a negative for large U.S. multinational companies. It makes exports more expensive. Some 40% of sales for the companies in the S&P 500 come from outside the U.S. So the combination of weaker growth abroad, potentially lower sales and adverse currency translations can dampen reported earnings.

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