Stocks slipped a little more than 1 percent in the month ending July 10. It was a relatively strong showing in light of ongoing events in Greece and China. Greece headed to the edge of default, and the Chinese stock market experienced a correction comparable to the crashes in 2008 and 1929. Commodities were hit during the month; oil prices fell more than 10 percent but equities and currencies were remarkably steady. Economic data was overshadowed, though it continued to point in a positive direction, and GDP growth estimates have moved steadily higher. The Federal Reserve left itself an excuse not to raise interest rates, namely a global slowdown caused by Greece or China, but at this point there are no signs of contagion.
Greece had to make several IMF payments in June and decided to lump them together into one payment at the end of the month while negotiating with creditors. It defaulted on the IMF payment at the end of the month and rejected European bailout terms in a referendum on July 5. Barely one week later, the Syriza-led government agreed to far harsher terms, including handing control of the country’s finances to creditors in exchange for three years of aid. It is unclear how this deal will remain in effect for the duration, given the Greek voters’ support for Syriza and their desire to bring an end to the existing austerity program. Furthermore, less harsh bailout terms were defeated by 60 percent of voters. If the deal is implemented it will likely calm the markets over the short term but has the potential to lead to another political crisis down the road.
It wouldn’t be a surprise if the Greek deal is rejected outright. On the other side of the table are Finland and Slovakia, who aim to push Greece out of the euro, along with German economists who argue that Greece cannot make the cuts required to stay in the union. The more humanitarian approach, and likely a more successful one, would allow Greece to exit the currency union for a period of time, potentially five years, and then return. The immediate impact of devaluation would be severe, but economies that experience currency devaluation typically recover within a year or two, and the recovery is an economic boom. Under this plan, Greece would receive humanitarian aid instead of loans in order to guarantee the supply of critical imports such as medicine during the transition phase.
While events in Greece have dominated the headlines, the market correction in China may prove to have a larger impact. The government panicked after the recent stock market correction turned into a crash. The Shanghai Composite fell 35 percent from its peak in mid-June and didn’t see a substantial rebound until July 9. The boom and bust were both fueled by leverage, much of it unofficial. Investors below the capital threshold required for official margin trading borrow from outside credit firms in order to reach the minimum. As a result, total leverage in the Chinese stock market may have exceeded 3 percent of GDP at the peak and more than 10 percent of trading. Many companies have pledged shares as collateral for loans, and, if stocks continue to fall, lenders will be able to liquidate the shares, possible touching off another selling wave. Finally, the housing market rebounded thanks to rising share prices, with the Shenzhen seeing prices rise more than 6 percent in the month of June alone. Following the stock market crash, there are reports of home owners trying to raise cash by selling homes despite falling prices, and home buyers refusing to make the down payments on new purchases.
Spurred by these initial signs of economic contagion, Chinese officials tried to stem the selling with a flurry of bailout maneuvers. Between public statements of support for the market and concrete efforts, there were well over a dozen moves made in the first week of July. Nothing worked until July 8, when most of the shares on the stock exchanges were halted. Many firms requested their shares be halted in order to keep pledged shares from being sold by lenders. Around the same time, the government said it would prosecute malicious short sellers, mentioning Morgan Stanley as one potential target. Weeks earlier, the bank said Chinese stocks were overpriced and likely to fall, making it one of the villains in China. Finally, there are also rumors that some brokers were refusing to take sell orders from customers. The combination of all these measures appeared to have an effect, and Chinese stocks rallied in the ensuing days.
China is the world’s second largest economy, and what occurs there is far more important for global markets than what happens in Greece. When China’s government began to clearly panic over the drop in equities, the prices of oil, copper, iron ore and coal all tumbled. The Chinese stock market is still relatively isolated from the global financial markets due to capital controls, but it is a major force in the commodities markets, which is why over the past month, commodities were some of the worst performing assets. Oil prices were also pulled lower by a possible nuclear deal with Iran.
As has been the case for much of the year, overseas events overshadowed the strong domestic economy. The Atlanta Federal Reserve’s GDP Now forecast of second-quarter GDP growth was only 0.8 percent when the second quarter began, but has now climbed to 2.3 percent. The trend in data is clearly to the upside, and the forecast could easily rise to 2.5 percent or higher in the final two weeks of July. But the final number reported at the end of July will likely differ from the GDP Now forecast. The government is changing the way it calculates GDP growth, and the new method should increase first-quarter GDP, while lowering GDP growth in the other three quarters.
Strong economic growth has interest rates on the verge of another bullish breakout in July, with the 10-year Treasury yield sitting at its highest levels for the year. Based on federal funds futures, there’s a 50 percent probability of a rate hike in September. The odds exceed 85 percent by December. This doesn’t tell us what will actually happen, but it tells us what the market is thinking right now. Since economic data has been improving, a continuation of this trend and lack of overseas trouble will increase the market odds of a September rate increase. In her most recent comments, Federal Reserve Chair Janet Yellen said she’s concerned about weakness in the labor market, which makes it sound as if she’s looking at December rather than September for the first increase. Even if the Fed has no intention of raising rates in September, rates will likely rise in anticipation as long as economic data improves in July and August.
Earnings season is underway, with the financial sector leading off. FactSet reports analysts are looking for 4.5 percent growth from the S&P 500’s financial sector. Thanks to rising interest rates, it has been among the better performing sectors in recent weeks. If economic data lifts interest rates and there’s positive guidance, the sector could make a strong challenge to health care for leadership of this bull market. The key to S&P 500 earnings is a different sector: energy. Analysts are looking for a 4.4 percent drop in S&P 500 earnings due mainly to an expected 57.4 percent drop in energy earnings. Oil prices didn’t start sliding until July, so this past quarter is another terrible year-on-year comparison. Overall, we expect earnings will rise for the S&P 500 Index, as they did in the first quarter. Three months ago, analysts were looking for first-quarter S&P 500 earnings to fall 4.8 percent, but they increased 0.8 percent