Is China or the Middle East a Bigger Threat to Stocks?

Is China or the Middle East a Bigger Threat to Stocks?

Brendan McDermid

The new year is already shaping up to be a nasty one for investors.

Just a few days in and North Korea claims to have detonated a hydrogen bomb, Iran and Saudi Arabia are at each other, the Dow Jones Industrial Average has lost the 17,000 level and big-cap favorites like Apple (AAPL) are on the skids as well-known catalysts (record app sales!) wear thin. The Federal Reserve is sticking to its guns on another four 0.25 percent rate hikes this year. Economic data here at home have been disappointing. And, of course, China, China, China after Chinese stocks plunged more than 7 percent in just 29 minutes of trading Thursday, triggering a circuit breaker that halted trading for the day.

On top of all that, the Q4 earnings season will kick off on Jan. 11 and is sure to be a heartbreaker: FactSet has S&P 500 earnings dropping about 5 percent, the third consecutive quarter of falling profitability. That hasn't happened since the financial crisis.

Related: Soros Warns We May Be Repeating 2008 Crisis

But above all, the meltdown underway in crude oil captures the headwinds stock bulls face. On Wednesday, crude fell below the $34-a-barrel level for the first time since early 2009. We're not far from levels last seen in 2003, as shown in the chart below.  

WTI Crude Oil Spot Price Chart

WTI Crude Oil Spot Price data by YCharts

The acute problem is a glut of supply, tepid demand and bloated inventories. The Department of Energy reported that gasoline inventories rose by 10.6 million barrels, the largest weekly increase since May 1993.

World crude oil production rose to a record 95.2 million barrels per day over the 12 months through November, according to Yardeni Research. This is up at a 2.4 percent annual rate, the fastest growth since July 2011 despite the price wipeout. U.S. shale and OPEC producers remain locked in a bitter struggle for market share, seeing whether American producers (hurt by credit constraints in the junk bond market) or the House of Saud (constrained by a budget deficit, military spending and falling currency reserves) cry uncle first.

Related: Why Oil Prices Will Rebound in 2016​​​

No surprise this smashed energy stocks, which lost 3.6 percent as a group on Wednesday. Chevron (CVX) lost nearly 4 percent. The drag from the energy sector is by far the biggest drag on overall earnings growth, with a 66 percent year-over-year drop predicted for the fourth quarter.

Other factors include the consequences of a stronger dollar as the Fed commits to its tightening bias. In China, the Caixin services activity index fell to a 17-year low.

On the U.S. economic front, the misses keep rolling in: The November factory goods and durable goods reports were both disappointing. Factory orders dropped for the 13th month in a row, which is something that has never happened outside of a recession.

As a result, the Citigroup U.S. Economic Surprise Index — which measures where the economic data is coming in against analyst expectations — dropped to lows not seen since early 2015 as the deflationary pressure from lower energy prices and lower energy earnings filters out into the economy.

While cheap oil is good for American drivers, with wholesale gasoline prices falling to 2009 lows this week, it has a dampening effect on everything from Texas home prices to transportation jobs and demand for tubular steel. No wonder the Atlanta Fed's GDPNow real-time tracking estimate of Q4 GDP growth has collapsed to 1.0 percent — down from nearly 3.0 percent back in November.

The one big wild card is the rising geopolitical tension between Iran and Saudi Arabia after Riyadh executed a well-known Shia cleric. Diplomats were recalled. Air service was halted. The Saudi embassy in Iran was attacked and set alight. Fingers were pointed. This lessens the already small chance of OPEC cooperation to reduce output and stabilize prices.

Thus, so far, it's been considered a negative catalyst for energy prices.

But if the spat devolves into an active shooting conflict or results in social unrest in Saudi Arabia's Shia-dominated oil-rich al-Ahsa province, all bets are off. Most of the Kingdom's 10.3 million barrels per day of production transits this region on the way to oil tankers in the Persian Gulf.

Related: Saudi Arabia May Have Picked a Fight It Can’t Win​​

Saudi Arabia has since bombed Iran-backed rebels in Yemen. Qatar recalled its ambassador from Tehran. Jordan, Djibouti, Bahrain, Sudan, the U.A.E., Kuwait and Turkey have all supported Riyadh's position. Tehran claims Riyadh is fanning the flames out of fear of Iranian market share gains (in the wake of the nuclear deal) and has proceeded recently with ballistic missile tests in possible violation of a U.N. ban.

It's darkly humorous that the fate of the stock market, corporate earnings and energy sector employment depends on a religious feud that started with the death of Muhammad some 1,400 years ago. But that's what fate has delivered.