A new year has dawned, and with it a fresh list of Very Bad Things people fear will roil markets over the next 12 months. Some are new(ish), like the OECD’s warnings of a looming global property crash. Others—Chinese bonds, foreign outflows from US Treasury markets, the advent of President Trump, European populists—are retreads with a fresh twist. It rather reminds us of this time last year, when everyone was sure a crashing China, plunging oil prices, negative rates and Italian banks would derail the bull market. None did. Neither did Brexit, Trump or any of the other big fears that plagued investors as the year wore on. Every year in every bull market is packed with false fears—plausible-sounding stories that dominate news coverage and frighten investors, until reality proves them wrong or folks move on. 2016’s big fears proved false, and stocks rose past them, showing the importance of staying patient and critically assessing today’s scary headlines.i
Chinese stocks crashed hard as the year began, and investors freaked as officials appeared to devalue the yuan for the second time in five months. Weak manufacturing PMIs triggered another round of “hard-landing” worries. As capital controls relaxed, over half a trillion dollars flowed out, weakening the yuan and (many feared) China itself.ii As the year closed, some argued “mindless Chinese stimulus” was inflating a corporate bond bubble, as China’s total debt-to-GDP ratio hovered around 300%. Yet for all the chatter, China did fine. GDP growth stayed near the government’s target, most recently hitting 6.7% y/y in Q3, and monthly economic data stayed firm. The yuan’s gradual slide has been carefully managed—Chinese authorities aren’t about to risk social upheaval by permitting sudden, deep depreciation. As for the much-feared debt, which features on 2017’s “scary things” list, a good chunk of that supposedlyiii $30 trillion in debt is bank loans. Troubled bank loans, perhaps, but the government has experience with recapitalizing banks. Corporate bonds held by private investors are a much smaller, manageable segment of the market. And whether it’s struggling manufacturers or financial firms, the government seems willing to spend portions of its $3 trillion in foreign-exchange reserves on limiting or cushioning defaults. But above all else, hard-landing fears have swirled since 2011. Markets are well aware, sapping surprise power.
First, folks worried slumping business investment (stemming from cutbacks in Energy) would pull the economy into a recession. And indeed, business investment did fall in Q4 2015 and Q1 2016. But under the hood, it was readily apparent investment outside Energy was holding up fine, and total business investment resumed growing modestly in Q2 and Q3 2016. Second, when low gas prices didn’t spur a consumption boom, folks lamented even “stimulus” couldn’t boost tepid growth. But this was always a false hope. Spending on gasoline is included in broader consumer spending. Even if folks spent all the money they saved at the pump, total spending wouldn’t change—you’d just see more spent on discretionary goods and services, and less on gas. Psychologically, cheap gas might feel like a rise in your disposable income, but from an economic perspective, it isn’t.
Before the Brexit referendum on June 23, most experts believed two things: 1) Brexit wouldn’t happen; and 2) on the outside chance it did, recession was all but assured as foreign investors fled and gilt yields spiraled higher. When “Leave” won, UK stocks dipped -5.6%iv in the next two trading sessions, but erased those losses in days and have climbed since. Gilt yields fell. Foreign investors kept investing. The economy powered ahead. Sterling fell, but that was likely heavily influenced by expectations for more quantitative easing and a rate cut, which the Bank of England announced several weeks later. Brexit could eventually take a toll (or be a net benefit), depending on how exit negotiations go. But talks will likely take at least two years, and all sides are incented to preserve strong trade ties.
Many believed markets had priced a Clinton victory and would have to suddenly digest the risk of a protectionist, chaotic Trump administration if he won. But markets mostly moved higher after November 8,v as they’ve done since February.vi Entering 2017, people fear trade spats and badgered exporters. But we advise watching what politicians do, not what they say—and expect Trump to do less than most imagine next year as gridlock gets in the way.
Though these were around since 2014, the world really started fearing them in early 2016—that they’d crunch lending (particularly in Europe) and slash banks’ profits. When negative rates spread to sovereign bonds, worries grew about a “bond bubble”—an irrational piling into fixed income as stocks appeared too risky or flat. But eurozone bank earnings actually did ok, and loan growth even accelerated. People also got more used to negative-yielding debt, which wasn’t a bubble—just a function of supply and demand. Sovereign debt supply was limited, as issuance was down and central banks were buying trillions of dollars’ worth. Meanwhile, individual and institutional investors competed for a shrinking pool of bonds. This meant high prices—and bond yields move inversely with prices. These worries have quieted today, as long-awaited consequences didn’t materialize and rates ticked higher.
European bank jitters persisted, however, especially around Italy and Deutsche Bank. Early in 2016, yields on Deutsche’s contingent-convertible bonds spiked; later, the German bank received a $7 billion finevii for mortgage-related improprieties, leading some to start preparing its obituary. Conflating the fall in its market capitalization with failing finances made a bad cash-flow period look like insolvency. But the fine was a small slice of Deutsche’s $250 billion in liquid assets, and the furor over European banks’ “coco” bonds subsided by August, as regulators clarified some rules and investors perhaps realized rising coco yields don’t signify imminent collapse. Shaky Italian banks keep eurozone Financials’ fears alive presently, but as time goes by without disaster, investors’ angst may fade.
False fears are part of what makes a bull market—without them, markets would reflect fundamentals pretty accurately, leaving stocks without a wall of worry to climb. Surprises move markets, not stuff you see splashed across headlines daily. The real time to worry is when no one else does.
i This article only features the absolute scariest fears, or at least the most prevalent. Here are some others we had to leave on the cutting room floor: deflation, inflation, disinflation, euroskeptic populism, oil’s correlation with stocks, rising protectionism, terrorism, fed hikes, QE running out of ammunition, not enough fiscal stimulus, the yuan as a reserve currency, an earnings recession, a manufacturing recession, a restaurant recession, just a generic recession and probably more.
ii Since June of 2014, China has reportedly spent nearly $1 trillion in forex reserves to support the yuan and battle outflows.
iii We say “supposedly” because there is no official data, and estimates come from scholars who are observing, tallying data from a multitude of sources and mostly making educated guesses.
iv Source: FactSet, as of 06/30/2016. MSCI UK total returns (in GBP), 06/23/2016 – 06/27/2016.
vTo be precise—5.12% as of 12/30/2016, according to FactSet and Global Financial Data.
vi Not that we’re calling it a Trump Rally—rather, the rally that began after the correction ended in February (and continued through Brexit’s aftermath) kept on running. We suspect stocks would have done fine either way, as just knowing who the next president will be reduces uncertainty, which stocks like.
vii Initially, the Department of Justice demanded $14 billion, but such fines always get negotiated down significantly.