Have Central Banks Run Out of Weapons?

Volatility has shot higher in the past two weeks as the major U.S. indexes sink below uptrend support that has persisted since 2012. The declines confirm the internal, hidden weakness that we have been discussing since mid-summer, when many measures, such as market breadth, small-cap stocks, and other measures topped out.

The theme that has supported this bull market and economic recovery — the idea that nothing bad would happen as long as central banks were providing cheap money stimulus — is beginning to crumble.

Two things have happened …

One is that outside of the U.S., economic growth has hit a wall. No surprise then that Vanguard MSCI World ex-USA Index (VEU), a great proxy for major stocks outside the U.S., has returned to levels last seen in September 2013.

The focus was on Germany last week, where industrial production, factory orders, and export activity all posted the worst results since early 2009 amid chatter that the country is on the verge of falling back into a technical recession.

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Separately, France is having budget trouble. And the euro-zone debt crisis threatens a comeback as credit rating agencies issue new downgrades and the market starts to realize that the European Central Bank can no longer bluff its way out of trouble, but must step up with a big sovereign bond purchase stimulus program (which could be illegal according to its charter and is an unpopular idea with the Germans) after playing at one for more than two years.

Japan is also at risk of falling back into recession (GDP growth already contracted last quarter) as a recent sales tax hike and the negative impact of a very weak yen (higher food, fuel, and import costs) pinch consumers.

Japan has been held together by the idea that the Bank of Japan would issue more cheap money stimulus and further slam the yen if the economy faltered. But economists are realizing that a weak yen is hurting more than it’s helping at this point. Given Japan’s massive 227 percent national debt-to-GDP ratio (vs. around 100 percent for the U.S.), time is running out.

And in China, the People’s Bank of China is watching as Chinese electricity production contracts outright for the first time since early 2009 in an anecdotal sign that the economy has hit a wall. But the temptation to indulge in more credit easing — as it did earlier this year in response to the “Credit Equals Gold #1” bad bond scare — would merely exacerbate the underlying problem of overreliance on debt-fueled growth and overcapacity in key industries like steel.

The second thing: The Federal Reserve is watching as its efforts to merely return monetary policy to a more neutral footing — by bringing to an end the QE3 bond purchase program and looking ahead to the first interest rate hike since 2006 — has resulted in volatility in the corporate bond market and a massive, dangerous rally in the U.S. dollar.

This has crushed commodity prices, tightened credit to foreign economies (many of which have grown dependent on borrowing at low rates in cheap dollars), and threatens to slow U.S. GDP growth by pinching exports. And now, with the Q3 earnings season getting underway, Wall Street is worried that companies are going to downgrade forward guidance because of the negative profit impact from a strong dollar, since it reduces the value of overseas earnings.

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This is coming at a time when the Bureau of Economic Analysis’ preferred measure of corporate profits — which puts depreciation on an economic basis and removes accounting gimmickry like inventory profits — is dropping at a pace normally seen in recessions. As shown in the chart above, this measure of profits is already falling at a rate on pace with the one seen during the dual recessions of the early 1980s.

The more dovish officials at the Federal Reserve, including new vice-chairman Stanley Fischer, have already responded by saying a loss of momentum in the U.S. economy could cause the Fed to slow its pace of policy normalization. With the unemployment rate at 5.9 percent (hitting the Fed’s year-end target months ahead of schedule) and the job market tightening (job openings at 2001 levels), it will be hard to justify this in the near term.

But if it happened in the medium term, would slowing the pace of normalization be enough? Considering that the monetary base has already swollen from $800 billion before the last recession to more than $4 trillion now, and that bond yields have been near historic lows for years, would a full turn-about to do more bond-buying stimulus make a difference?

While you ponder that, note that it wouldn’t do much to help Germany, Japan, or China deal with their specific set of problems. Nor is it clear that it would reverse the slide in corporate profits or the rise in corporate bond spreads — both of which are combining to slam the brakes on the share buyback programs that have been a big boost to the stock market over the last two years.

These are big questions with no easy answers. Just the nagging feeling that maybe central banks have already done all they can and that it’s time for new strategies, or for nature to take its course.

You have to imagine that someday governments and companies will have to address deeper, structural problems that remain unresolved. Here at home, that includes a broken tax code, dilapidated infrastructure, unreformed entitlement programs, a national deficit that’s set to never close, a screwed up healthcare system, subpar education system, regulatory morass, and a worrisome decline in entrepreneurship.

No one can say what happens next. But what’s a touch more clear is that something appears to be ending. I’m not just talking about the 40-week moving average on the S&P 500. It’s bigger than that.

It’s the general feeling that the smooth sailing the world has enjoyed since 2012 — when the ECB threatened a sovereign bond buying program and ended the euro-zone debt crisis, when the Fed launched QE3 and ended a deflation scare, when the People’s Bank of China stopped worrying about inflation and opened the credit taps, and when the Bank of Japan launched the first phase of “Abenomics” by destroying the yen with cheap money stimulus — are over.

And with investor sentiment coming off of record highs, we’ve yet to see the cathartic panic of the kind we saw back in 2011 after the U.S. credit rating downgrade much less a wholesale sentiment collapse of the 2000 or 2008 variety.

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Market breadth continues to deteriorate as fewer and fewer survivors — i.e. big staples producers like Coca-Cola (KO) and Procter & Gamble (PG) — resist the downside pressure.

As a result, I expect the fireworks to continue at the very least through November as more wildcards — the mid-term elections, the potential return of knockdown budget battles between Congress and the White House, the Ebola contagion threat and the collapse of oil demand — are thrown into the mix.

Near term, my expectation is that bulls will make a valiant effort to take advantage of last week’s price and sentiment smackdowns to rally stocks this week. Wall Street is likely to at least gin up some excuse for a rebound, such as dovish comments from Fed leaders, some surprise M&A, a much stronger than expected earnings report or just outright bargain-hunting.

The quality and extent of that rebound, should it materialize, will provide clues about the rest of the month and quarter. I don’t take the MacroSwitch sharp decline lightly, however, so no matter how sharp a snapback manages to emerge I will recommend lightening up.

The next line in the sand on the S&P 500 is 1845, which was the close on the first day of the year. That’s 3.2 percent lower than the Friday close. Should that level give way, a much larger drop would be in store; the next key level to watch is 1741, the February low, and then 1700, which is the long-term trendline.

Best wishes,

Jon Markman