Why is Dow Jones plummeting?

The Dow Jones Industrial Average continued its New Year fall by slipping over 400 points through the day on January 15, 2016. The index that started the year at 17,405 was down almost 1500 points and hovered below 16,000 for the first time since August 2015. The big question on everyone’s mind is – why the rapid fall and should we be concerned about a recession already? According to me, these are the major reasons for Dow’s incessant drops-

1) China’s Economic Turmoil

China is the world’s second largest economy after the United States. It touches businesses and countries around the world. China is also the third largest export partner (the first and second being Canada and Mexico respectively) of the U.S., making up about 5.3% of the total U.S. exports in 2014 (good and services valued at roughly $124 billion). China also happens to be the biggest import partner of the U.S, accounting for 16.4% of the total imports of the U.S. in 2014 (roughly $467 billion). Thus, the trade balance (exports minus imports) of the U.S. vis-à-vis China is negative. The deficit is financed partly by the capital flow from China. This makes China the largest creditor of the U.S. as well, holding the largest part of U.S. treasury securities - amounting to $1,270 billion in May 2015. That is about one-fifth of the total U.S. treasury securities outstanding.

These numbers give a clue about how any positive or negative economic developments in China can affect the U.S. economy. For example, a decrease in the level of consumer spending in China, owing to a falling economy, will affect U.S. exports negatively which in turn will lead to a decrease in the U.S. GDP. Additionally, with exports decreasing but imports remaining largely unaffected, the deficit in the US balance of trade with China will widen further. Unemployment will also increase in U.S. companies that generate a major part of their revenues from Chinese exports.

Another problem that China might pose for the U.S. is the selling off of U.S. treasury securities to use the proceeds to provide stimulus to its economy. Potential massive selling of U.S. securities will create a threat to the U.S. economy because a large supply of such securities will pull the prices down. Unexpected increase in the interest rates may also increase pressure on GDP growth through lower valuation of investments.

Largely speaking, China matters greatly to the world. Its explosive growth and a huge appetite for Chinese goods and raw materials lifted economies in Europe, Asia, Latin America, Australia and elsewhere. As a result, it becomes obvious that China’s slowdown is having a huge ripple effect around the globe. Concerns about China’s economy are amplified by the fact that it remains a bit of a black box to investors. Few trust the accuracy of Beijing’s economic stats and many believe that actual growth is a lot lower than government reports.

The devaluation of the Chinese yuan that began in August 2015 has led to global markets falling by 7.1% since January 1^st this year. China’s economy continues to remain caught in a dangerous no-mans-land between market and state control. Hence, the jitters are also being felt and seen on U.S.’s Dow Jones index (along with other local indexes).

2) Falling Oil Prices

We are currently in the midst of a great oil collapse. Global share markets, including the Dow Jones, tumbled at the prospect of an end to the Iranian oil export ban. Prices have slipped below $30 a barrel for crude oil (lowest since 2003). News is that Iran could restart its oil exports (after lifted sanctions) as early as this weekend if the International Atomic Energy Agency (IAEA) confirms that it has complied with measures to curb its nuclear programme. Iran has the world’s fourth largest proven oil reserves and any additional oil would add to the 1 million barrels a day supply that has already led to more than a 70% collapse in oil prices since the middle of 2014. In simpler terms, oil supply has outstripped demand globally.

The demand for oil from China has fallen as its economic growth has slowed. Meanwhile supply has increased, partly due to the rise of US shale oil. In addition, Saudi Arabia (the world’s largest exporter of oil) has refused to cut production – something it has done previously to support oil prices. Experts estimate that about one million barrels of oil are being produced above demand every day. While consumers and some businesses have benefitted from lower oil prices, oil-exporting nations have suffered. Thousands of jobs have been lost in the oil industry.

Crude oil trades in U.S. dollars. That means when the dollar gets stronger, oil gets more expensive for overseas buyers. While cheap oil is great for American consumers, it continues to contribute to the losses in the stock market. Shares of S&P 500 energy companies are already down 10% so far this year. Some others like Marathon Oil and Anadarko Petroleum have plunged over 20%. The same trends are playing out on the Dow Jones index. Investors are worried that historically cheap crude is an ominous sign that global demand is far weaker than economists think.

Bottom line

The rout of the Dow Jones index is in tune with a global crash in stock markets, owing largely to global factors such as the fall of the Chinese economy and plummeting oil prices. Experts say that local factors like deteriorating corporate earnings and revenues, overvaluation of stocks and rising interest rates could also be contributing to the collapse. Some investors are also playing safe and dumping their stocks before the long MLK weekend. Maybe it is good advice to stay un-invested for now and observe where the stock market heads before making any monetary bets. The year looks bearish, the emotion is cautious and it is prudent to listen to money management gurus who say that it's better to be safe than sorry!