What Credit Markets Are Telling Us About Stocks Now

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MoneyMorning.com Michael E. Lewitt writes: Rather than trust markets to heal themselves, the world's central banks have polluted markets with flawed economic theories and trillions of dollars of debt. Rather than ignite economic growth as they had hoped, however, they have suffocated the global economy.

It began with the U.S. Federal Reserve's move to lower interest rates to zero seven years ago, followed by several bouts of quantitative easing.

This was followed by Mario Draghi's August 2012 declaration to do "whatever it takes" to defend the euro.

And then there were the Bank of Japan's kamikaze moves last Halloween to buy not only every Japanese Government Bond being sold, but even stocks and ETFs.

China is late to this central banking party, but it still managed to rock global markets last week when it devalued the yuan.

Central banks have launched a massive assault on markets that has sucked out their liquidity and distorted normal pricing mechanisms beyond recognition. What we've seen so far is only a taste of what central banks will do in their desperation to prop up over-indebted economies…

The Last Best Hope for Growth

China, of course, has been the primary engine of world growth since the financial crisis.

Unfortunately, it has done so while destroying its environment and drowning its economy in debt. We now know that China's debt grew from $7 trillion in 2007 to s$28 trillion in mid-2014, according to the McKinsey Global Institute.

We also know that China grew by first inflating a real estate bubble, then a bubble in financial products sold through its shadow banking system, and finally an epic stock market bubble that saw its three major stock exchanges (the Shanghai, Shenzhen, and ChiNext) rally by between 200% and 300% in less than a year.

The final – terminal – stage of this bout of bubble blowing was actively aided and abetted by the Chinese government, which encouraged millions of uneducated Chinese farmers and others to open margin accounts and borrow themselves into permanent insolvency.

The government also propagandized the stock market bubble as a sign of the regime's economic genius, leading to such epic stupidity as telling people to buy stocks on Chinese leader Xi Jinping's birthday.

When Chinese stocks finally hit a wall a few months ago, fantasy hit grim reality and, like in Game of Thrones, the Red Wedding began.

Chinese economic growth began to slow in early 2014, something that astute investors noted as they began backing away from commodities. The commodity sell-off is directly tied to China, which has been the marginal buyer of all major commodities since the financial crisis as it built massive ghost cities and tried to create a consumer economy overnight.

Even Apple Inc. (Nasdaq: AAPL) has benefitted from massive sales of iPhones in the China market, which have now slowed and (for now) nicked the stock of the most highly valued company in the world.

Commodity investors are among the most economically sensitive in the world, and when they see the prices of iron ore, aluminum, copper, and oil start weakening, people should pay attention.

While commodities are also getting badly hurt by the strength of the dollar, Chinese economic weakness is a major contributor to the 50%+ declines in prices in these key products.

Devaluing the Yuan May Have Been the Only Option

Having effectively panicked and shut down the normal functioning of their stock markets, Chinese authorities took the next step in their efforts to stabilize their economy last week by devaluing their currency against the dollar.

On three consecutive days, they set the value of the yuan just a little lower against the U.S. currency. While their motives are being endlessly debated, the fact remains that the yuan had been appreciating sharply against the dollar in recent years.

More important, perhaps, is that it had appreciated even more sharply against the Japanese yen, which is being actively debased by the Bank of Japan as a main approach of "Abenomics."

A full-scale currency war is raging in Asia, and China's currency (along with the South Korean won) has been on the losing side. South Korea's export economy is teetering on the edge of recession and most likely so is China's – or at least some regions of China.

China's moves may not yet be enough to level the playing field with Japan, but they are significant and are likely to continue, which will continue to rock global markets in the weeks and months ahead.

A weakening yuan marks a sea-change for a currency that had been strengthening against the dollar for years. Combined with a likely Fed interest rate increase in September, the trends that have dominated global finance since the financial crisis are shifting under the feet of investors.

That suggests that the other dominant trend – higher stock prices – may also be in store for a correction.

This Market Needs a Correction

But for the moment, the major indices are holding on. The Dow Jones Industrial Average is down 1.94% on the year, while the S&P 500 Index is up 1.59% year to date and is only about 2% below its all-time high. The Nasdaq Composite is up 6.59% for the year.

These market-weighted indices are disguising serious damage in individual sectors and stocks, however, as anything commodity and particularly energy-related has been decimated. Other sectors such as media have also seen serious damage.

The high-yield bond market has also sold off hard in August with the average yield in the market rising to 7.3%, its highest level in quite a while.

The large high-yield bonds ETFs, SPDR Barclay's Capital High Yield Bnd ETF (NYSE Arca: JNK) and iShares iBoxx $ High Yld Corp Bond (ETF) (NYSE Arca: HYG), have sold off about 2% month to date.

Credit markets usually signal trouble ahead in equities, so investors should be paying attention to this potential canary in the coal mine.

But a great deal of damage has already been done under the surface of the stock market. The real question is whether the indices, which are driven by their largest cap stocks, will ever give up the ghost.

My bet is that they can't hold out much longer unless some good news arrives at their door soon.

Source :http://moneymorning.com/2015/08/17/what-credit-markets-are-telling-us-about-stocks-now/

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