The sharp rally in equity markets, particularly in the USA, was very painful for the bears! In fact, the arguments were on their side. A weak global economy with an industrial sector in recession and US corporate earnings growth that has been declining for at least three quarters. This has widened the gap between fundamentals and valuations/prices.
But none of this seemed to matter. The economy and corporate earnings would soon recover (and indeed, data from German industry in particular showed a slight improvement). Add to this a cascade of interest rate cuts by central banks and above all the Fed’s dovishe turnaround. Instead of interest rate hikes then suddenly interest rate cuts, T-bills purchases and intervention in the repo market. The result was a strong expansion of the Fed’s balance sheet. The monetary factor was the only decisive element for the stock markets, everything else was just auxiliary. It was often overlooked that even the massive injection of liquidity into the system did not really change growth significantly. You need more and more newly printed Dollars (or even Euros) for ever lower growth. This is the central argument of the bears. Since the financial crisis, debts have been growing faster than the economy! All this has also been shown by the US tax reform. The promised growth of the US economy failed to materialize, investments declined, the resulting costs massively increased the debt.
Meltdown in China
But with the coronavirus, a new motive has suddenly emerged. The tale of economic recovery is faltering with the de facto collapse of China. lt is the first real reason for a correction for heavily overbought stock markets. Citigroup put it in a nutshell over the weekend. Extremely high valuations on the stock markets combined with ever dwindling opportunities for central banks:
“What we find particularly troubling is the potential interaction between the shock from the virus, already stretched market valuations, and central banks approaching the local limits of their ability to prop up markets.”
Sven Henrich analyses the chart situation of the stock markets (and other markets) after the sell off on Friday. How far does the correction go, or is it already over?