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Stock Market Threats Far Wider Than Just North Korea

Business, China, Company Strategy, Economics, Oil & Gas, US
By John Richardson on 14-Aug-2017

hqdefaultBy John Richardson

LAST WEEK’S steep fall in global stock markets was of course the result of rising US-North Korea geopolitical tensions. Some $1 trillion was wiped off equity values. We obviously all hope that the geopolitical tensions will ease.

But that would still leave behind a bull-run in global equities that has mainly been driven by just a handful of companies.

And these companies are not creating enough good-quality jobs in the economy occupied by the majority of people in the US and in Europe.

So, even if the war of words between the US and South Korea calms down, do not assume that a major and much deeper correction in markets is a long distance away.

As John Plender points in out in this FT article, a lot of the strength of the S&P 500 has been driven by just a handful of companies – Facebook, Apple, Amazon, Netflix and Google (now Alphabet), which we all know as the “FANGS”. Just a few negative earnings reports from these companies and we could be in trouble.

You think this time is going to be different? Plender points to three phases of stock market history when investors were similarly convinced that nothing could go wrong:

  1. The “Nifty Fifty” era of the 1960s when you could buy companies with sky-high price/earnings multiples without any concern that this wouldn’t translate into equally stellar profits. But the Nifty Fifty included companies such as Xerox and Polaroid which were overtaken by technology.
  2. Then it was the turn of the oil majors, thanks to OPEC production management and geopolitical crises that caused the oil-price spikes of the 1970s. Prices crashed in the 1980s as the high cost of crude dented demand and led to greater energy efficiency.
  3. Then came the dot.com bubble which went pear-shaped in 2001. There were again some very shaky companies in the mix  who had sky-high valuations but never turned a profit.

A growing income divide

I also see another pitfall here, which Rana Foorohar highlighted in another FT article. It is that the tech and also finance sector (financial companies are also behind today’s stock market boom) are not delivering broad-enough based economic value. She writes:

Finance takes 25% of all corporate profits while creating only 4% of jobs, since it sits at the centre of the deal-making hourglass, charging whatever rent it likes.

Meanwhile, wealth and power continue to flow into the technology sector more than any other — half of all American businesses that generate profits of 25 per cent or more are tech companies.

Yet the tech titans of today — Facebook, Google, Amazon — create far fewer jobs than not only the big industrial groups of the past, like General Motors or General Electric, but also less than the previous generation of tech companies such as IBM or Microsoft.

Donald Trump’s success in last November’s presidential election was a result of the anger of many middle class Americans who often do not own shares.

They have borne the brunt of job losses and reduced income growth resulting from automation, the growth in the internet economy – and most importantly of all, I believe, the drag on economic growth resulting from the retirement of the Babyboomers.

Here we come in full circle. It is Donald Trump through his his hard line rhetoric towards North Korea that led to last week’s stock market sell-off.

There also remains his threat to upend the global free-trade order, with China still a potential target for US protectionism – especially, perhaps, if President Trump decides that China hasn’t done enough to help defuse the North Korean crisis.

Supporters of President Trump argue that these approaches will prove right in the long term. That is debatable.

But what is not in doubt is that for the vast majority of time President Trump has been in office, equity markets have done nothing but boom.

This isn’t just down to the FANGS only. Confidence of investors in general is high because of his pledges to reform the US tax system and introduce a major infrastructure spending programme.

Herein, though, lies another risk. After the failure to reform healthcare, the rest of President Trump’s legislative agenda looks to be in jeopardy.

Again, none of this is meant to be a comment on the rights or wrongs of President Trump. I am just trying to state the risks for investors.

As long as there is lots of cheap money

Other threats to the stock market bubble include China and its economic slowdown. A slower China would throw into stark relief the weak foundations of the economy recovery in the US and other western economies.

A slowdown in China might also occur as the Fed and the ECB raises interest rates and start to pull back from overall quantitative easing programmes. This could cause a widespread sell off as it becomes apparent that quantitative easing has failed to remedy the problems of the real economy.

Russ Koesterich, Portfolio Manager for BlackRock’s Global Allocation Team, said this of the importance of cheap financing.

At this stage of the bull market, investors are contending with more than a few enigmas: Do valuations even matter? Will interest rates ever rise? And how do you explain the divergence between U.S. political dysfunction and the unnatural calm in financial markets?

That last one has become particularly troubling. Most volatility measures are near all-time lows while Washington appears in complete disarray. Nonetheless, investors are likely to continue to look past political dysfunction, at least as long as financial conditions remain this easy.

For chemicals companies, the risk is that as equities tumble so will other asset classes including crude oil.

When? Perhaps as soon as this September if it becomes evident by then that the slowdown in Chinese lending growth has fed through to key data points such as industrial production and imports of raw materials.

Or the bubble could go on and on. But I worry that this will do little to address the underlying problems faced by western economies.