Is the adjustment of the US stock market in place?

Core Viewpoints

1. The US dollar is the anchor for global cross-border capital flows. In the context of a strong dollar, US stocks are likely to outperform non-US stock markets; in the context of a weak dollar, US stocks underperform non-US stock markets. The prolonged period of a strong dollar since 2018 has changed the nature of dollar credit, causing non-US economies to remain in a state of credit contraction and seek to escape the dollar system. Therefore, since 2018, US stocks, the dollar, and gold have fluctuated in the same direction, with the central tendency shifting upward. Meanwhile, in the past two years, global assets have become more sensitive to the dollar, with the dollar, US stocks, gold, Chinese government bonds (prices), the CSI 300 Dividend Index, and bank stocks even fluctuating in the same direction. The shift in global risk appetite this year is also a result of the dollar's decline from 110 to 103.5.

2. The sustained strong dollar since 2018 has intensified the siphoning effect of US stocks, concentrating global liquidity more in US stocks. If the "Mar-a-Lago Agreement" drives the dollar into a long-term depreciation cycle, it is not ruled out that the story of the dollar and US stocks peaking and retreating in 2000 may reoccur. So, how did US stocks peak in 2000? Looking at the sequence of peaks in the three major indices, the Dow Jones Industrial Average, representing the fundamentals, peaked first on January 14, 2000, followed by the Nasdaq on March 10, and the S&P 500 on March 24, suggesting that fundamentals peaked before valuations. However, from the performance of the three major indices, it was actually valuations that peaked before fundamentals, with the S&P 500 and Nasdaq experiencing significantly larger declines than the Dow, which had been building a peak for nearly a year. Considering the background at that time, valuations indeed peaked before fundamentals: excessively high valuations + continuous interest rate hikes → net inflow of hot money decreases → Nasdaq plummets → wealth effect shrinks → service sector employment declines → economic downturn → US stocks continue to plunge.

3. However, the decline of the dollar and US stocks is not instantaneous. In the short term, there have been three scenarios of US stock adjustments over the past 20 years. The current situation resembles scenario three, but it is very likely to transition to scenario two before US stocks rebound again.

Scenario 1: Systematic sharp decline: S&P 500 down about 50%. 1) In 2000, the tech bubble burst, and the index fell by 49.1%; 2) From 2007 to 2009, the systematic pressure in the real estate sector triggered the subprime mortgage crisis, and the index fell by 56.8%.

Scenario 2: Economic downturn cycle: S&P 500 down about 20%. 1) In Q2 2010, the spread of the European debt crisis and expectations of the Federal Reserve exiting quantitative easing led to a 16.0% decline in the index; 2) In Q4 2011, US economic stagflation resulted in an 18.3% decline in the index; 3) In Q4 2018, the tapering of tax reform benefits and escalating trade frictions triggered stagflation, leading to a 19.6% decline in the index; 4) In February-March 2012, a liquidity crisis caused a severe economic downturn, with the index falling by 33.9%; 5) From January to October 2022, rapid inflation and the Federal Reserve's continued tightening led to hard landing expectations, with the index declining by 25.4%.

Scenario 3: Disturbance factors: S&P 500 down about 10%. 1) In July-August 2015, rising expectations of Federal Reserve interest rate hikes and the "8.11" exchange rate reform led to a 12.2% decline in the index; 2) From November 2015 to February 2016, the Federal Reserve's interest rate hike and rising expectations of continued rate hikes resulted in a 13.2% decline in the index;3) In Q1 2018, the expected tax reduction policy was realized, and the index fell by 10.1%; 4) From August to October 2023, the expectation of interest rate hikes by the Federal Reserve increased, along with concerns about debt issues, leading to a 10.3% drop in the index; 5) From July 16 to August 5, 2024, the yen carry trade reversed, resulting in an 8.5% decline in the index.

IV. Has the adjustment of the US stock market been completed since the beginning of the year?

This round of adjustment resembles a combination of early 2018 and late 2018. On one hand, this round of adjustment in the US stock market is a response to the elimination of Risk-on expectations brought about by Trump's policies after he took office, similar to the pullback after the realization of tax reform expectations in early 2018. On the other hand, similar to the negative impact of the "tax reduction" policy fading at the end of 2018, the negative effects of tariff policies on China have become apparent, and this round of adjustment is also a repricing of Trump's tariff policies.

The US stock market has adjusted by about 10%. If the US economy is confirmed to be in recession, the stock market will undoubtedly adjust towards 20%, but currently, there is a lack of more evidence. Of course, according to the peak process seen in 2000, valuations can peak before the index, and the index can peak before the fundamentals. However, it is necessary for valuation factors to continue to be impacted, such as tariffs driving inflation, prompting the Federal Reserve to take action on interest rates.

What happens after a 10% adjustment? If the March FOMC meeting this week shows hawkish hints, the US stock market is very likely to replicate the script of December 2018 and continue to decline by 5%-10%. Looking further ahead, the trend of the US stock market will depend on changes in the Federal Reserve and Trump's subsequent policies. For the former, there are two scenarios: one is that after another 10% adjustment in the stock market, the Federal Reserve may release easing signals, leading to a halt in the decline of the stock market; the other is that the US experiences a rapid tightening of overnight liquidity similar to the collapse of Silicon Valley Bank in March 2023, and the Federal Reserve may provide liquidity to the stock market through the Bank Term Funding Program, potentially leading to a rebound in the stock market; for the latter, if the stock market continues to adjust without intervention from the Federal Reserve, and the recent "recession" narrative gives Trump more domestic political leverage, we may see the advancement of a new tax reduction bill and deregulation policies in the second quarter, which could also lead to a reversal in the stock market. The scenario we currently lean towards is: if the Federal Reserve's statement in March is hawkish, the stock market may still have adjustments in the short term, but in Q2, under the influence of a dovish shift from the Federal Reserve or support from Trump's policies, it may reach new highs, although pressure will gradually increase thereafter.

In addition, the "weak dollar" narrative since the beginning of the year may see a phase reversal in Q2, providing a boost to the US stock market. The dollar's pullback in Q1 stemmed from the narrative of the relative convergence of the US's advantages over non-US and the convergence of tariff premiums. However, in Q2, the aforementioned factors may marginally reverse, leading to a potential rebound in the dollar index. If the dollar rebounds, it may also positively influence the US stock market in Q2.

Main Text

I. The dollar is the anchor for global cross-border capital flows

(1) We are approaching the peak of the current dollar cycle

The strength or weakness of the dollar directly affects global liquidity and credit conditions. Under a strong dollar, the cost of liabilities for non-US entities rises, asset returns are lowered, private sector profitability weakens, and leverage (especially external leverage) increases, allowing the US stock market to outperform non-US markets; under a weak dollar, the cost of liabilities for non-US entities decreases, asset returns rise, private sector profitability strengthens, and leverage (especially external leverage) decreasesThe U.S. has underperformed non-U.S. assets. Over the past decade, the U.S. dollar index has remained strong, significantly boosting the siphoning effect of U.S. stocks, leading to a continuous flow of global cross-border capital from non-U.S. to the U.S., with the S&P 500 index consistently outperforming non-U.S. stock indices.

The peak of the dollar cycle is expected to occur in the next 1-2 years. Historically, the peaks and troughs of the dollar cycle are not dominated by U.S. fundamentals but are driven by certain events, particularly significant changes in non-U.S. economies. For example, after the outbreak of the Latin American debt crisis in the early 1980s, the dollar index bottomed out; after the Plaza Accord in 1985, the dollar index peaked and fell; the establishment of several bottoms in the dollar index during the 1990s corresponded to the dissolution of the Soviet Union, the bursting of the Japanese economic bubble, and the Asian financial crisis; the establishment of the Eurozone, China's accession to the WTO, and the "911" attacks confirmed the peak of the dollar. In fact, the confirmation of the end of the global pandemic in October 2022 may have already marked the peak of this dollar cycle (one of them). Looking ahead, the promotion of the Mar-a-Lago Agreement may be an important event for the dollar to peak and fall. As we pointed out in our March 4 report "Technological Revolution, Wealth Effect, and Economic Fluctuations," the prolonged strong dollar after 2018 has led to an extended global tightening credit cycle, which is a major reason why some non-U.S. countries are trying to break away from the dollar system. Therefore, in the following seven years, while the dollar strengthened, the proportion of dollar foreign reserves actually declined. Furthermore, the Mar-a-Lago Agreement, which was being formulated by the Trump administration, could stabilize the position of dollar foreign reserves while effectively suppressing the dollar index. However, a weak dollar will not happen overnight; if the Mar-a-Lago Agreement is successfully promoted in the next 1-2 years, leading to a depreciation of the dollar, global cross-border capital will shift from the U.S. to non-U.S. markets.

(2) Global assets have become more sensitive to the US dollar in the past two years

The current strong dollar has lasted too long, changing the nature of dollar credit since 2018, causing non-US economies to remain in a state of credit contraction and seek to break free from the dollar system. Since 2018, US stocks, the dollar, gold, and Chinese bonds (prices), as well as the CSI Dividend and bank stocks have fluctuated in the same direction, with the central tendency shifting upward. At the same time, global assets have become more sensitive to the dollar over the past two years, with the dollar, US stocks, gold, Chinese bonds (prices), CSI Dividend, and bank stocks even fluctuating in the same direction. The shift in global risk appetite this year is also a result of the dollar falling from 110 to 103.5.

2. How did US stocks peak in 2000?

The continued strong dollar since 2018 has intensified the siphoning effect on US stocks, concentrating global liquidity more on US stocks. Therefore, if the "Mar-a-Lago Agreement" drives the dollar into a long-term depreciation cycle, it is not ruled out that the story of the dollar and US stocks peaking and falling in 2000 may reoccur. So, how did US stocks peak in 2000?

Looking at the sequence of peaks in the three major stock indices, the Dow Jones, representing the fundamentals, peaked first on January 14, 2000, followed by the Nasdaq on March 10, and the S&P 500 on March 24, suggesting that fundamentals peaked before valuationsHowever, from the performance of the three major stock indices, it can be seen that valuations peaked ahead of the fundamentals, with the declines in the S&P 500 and Nasdaq significantly exceeding that of the Dow Jones, which has been nearing its peak for almost a year.

First, let's look at the valuation factors. In December 1999, the Shiller cyclically adjusted price-to-earnings ratio (CAPE) of the S&P 500 peaked at 44 times, the 10-year U.S. Treasury yield peaked in February 2000, the year-on-year CPI peaked in March, and the net inflow of cross-border funds also peaked in February. From June 1999 to May 2000, the Federal Reserve continuously raised interest rates. This sequence corresponds to the Federal Reserve's sustained interest rate hikes during a period of rising inflation and an overheating economy, which burst the bubble of high valuations in the U.S. stock market.

Subsequently, the fundamentals began to deteriorate. Historically, U.S. service sector employment has closely tracked the S&P 500, reflecting the service sector's high sensitivity to the wealth effect. After peaking year-on-year in April 2000, U.S. service sector employment quickly declined. Although the official manufacturing PMI peaked in November 1999, it did not fall below the neutral line until August 2000, while the official non-manufacturing PMI peaked at the same time. U.S. GDP growth peaked in Q2. Connecting the above clues, it is clear that valuations indeed peaked ahead of the fundamentals: excessively high valuations + continuous interest rate hikes → reduced net inflow of hot money → sharp decline in Nasdaq → shrinking wealth effect → decline in service sector employment → economic downturn → continuous sharp decline in U.S. stocks.

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III. Three Scenarios of U.S. Stock Market Adjustment

Although we believe that the turning point of the U.S. dollar's long-term cycle may occur within 1-2 years, the U.S. dollar and stock market entering a downward cycle is not an overnight process. Looking back at the past 20 years, there are three scenarios for U.S. stock market adjustments. The current situation resembles scenario three, but it is very likely to transition to scenario two before the stock market rebounds again.

(1) Systematic Heavy Decline: S&P 500 Drops by About 50%

The first scenario is a decline of about 50% (based on the S&P 500 index), corresponding to a systematic heavy decline. Apart from the previously mentioned 49.1% drop in the S&P 500 during the burst of the dot-com bubble in 2000, the U.S. stock market fell by 56.8% during the subprime mortgage crisis. Unlike the high valuations of technology stocks at that time, the subprime crisis was a systematic pressure from the real estate sector. After 2001, the Federal Reserve began a low-interest-rate policy, leading to a sharp decline in U.S. household savings rates and an increase in leverage. The U.S. subprime mortgage market also developed rapidly, causing households to leverage into the real estate market, with household leverage rates exceeding 100% at their peak. The total market value of U.S. real estate reached 2.2 times the total U.S. economy. In April 2007, the second-largest subprime mortgage company in the U.S., New Century Financial, filed for bankruptcy protection, followed by the iconic event of Lehman Brothers' bankruptcy on September 15, 2008, marking the onset of the subprime crisis. Investors began to lose confidence in the value of mortgage securities, triggering a systemic crisiswx_fmt=png&from=appmsg)

(2) Economic Downturn Cycle: S&P 500 Falls by About 20%

The second scenario is a decline of about 20%, which basically corresponds to an economic downturn cycle or deterioration of fundamentals.

Since 2018, the S&P 500 index has fallen by about 20% on three occasions, all coinciding with economic contractions. The first was from October 3 to December 24, 2018, with a decline of 19.6%, primarily due to the tapering of tax reform benefits and escalating trade frictions. The tax reform benefits from 2017 essentially ended in Q3 2018, compounded by the 10% tariff imposed by the U.S. on $200 billion worth of Chinese goods starting September 24, 2018, which had a stagflation impact on the U.S. economy, causing the actual GDP annualized rate to plummet to -28.1%; the second was from February 19 to March 23, 2020, with a sharp drop of 33.9%, mainly triggered by an extraordinary event (the pandemic) leading to a liquidity crisis and subsequent stock market crash, with the actual GDP annualized rate dropping from 2.5% to 0.6%; the third was from January 3 to October 12, 2022, with a decline of 25.4%, primarily due to rapidly rising inflation, the Federal Reserve's continued tightening of monetary policy, and rising 10-year Treasury yields, which raised expectations of a hard landing for the economy, causing the actual GDP annualized rate to plummet to -1%.

From 2010 to 2012, the S&P 500 index also experienced two adjustments of around 20%. The first was from April 23 to July 2, 2010, with a decline of 16.0%, but the U.S. economy appeared relatively resilient in Q2-Q3, with the actual GDP annualized rate remaining above 3%It seems that the decline is not caused by an economic cycle downturn, but at that time the market was concerned about two things: first, whether the European debt crisis would spread globally, and second, whether the Federal Reserve would stop easing after the end of QE1; the second decline occurred from July 22 to October 3, 2011, with a drop of 18.3%. At that time, the U.S. economy was in a state of stagflation, with the U.S. CPI reaching 3.9% in September 2011, while the actual GDP year-on-year growth rate was negative in both Q1 and Q3. On August 5 of the same year, S&P downgraded the long-term sovereign credit rating of the U.S. from "AAA" to "AA+", marking the first time in U.S. history that it lost its AAA sovereign credit rating.

In summary, it can be generally considered that if the S&P adjusts by around 20%, it is highly likely that the economic growth rate has shown a significant decline, but a decline in economic growth does not necessarily mean that U.S. stocks will have a correction of around 20%, as there may be other factors providing support for U.S. stocks during the same period.

(3) Disturbing Factors: S&P 500 Drops Around 10%

The third scenario is a drop of around 10%, mostly due to temporary disturbing factors, but not enough to trigger a systemic crisis.

Since 2018, the S&P 500 index has dropped around 10% three times. The first time was from January 26 to April 2, 2018, with a drop of 10.1%, mainly due to adjustments following the realization of expectations for Trump's 1.0 tax cut policy; the second time was from July 31 to October 27, 2023, with a drop of 10.3%. On July 10, 2023, the 10-year U.S. Treasury yield exceeded 4% for the first time since April 2010, and the surge in government bond issuance in August raised concerns about debt costs; the third time was from July 16 to August 5, 2024, with a drop of 8.5%. The rise in the unemployment rate in July 2024 triggered concerns about recession due to the "Sam Rule," combined with the Bank of Japan's interest rate hike, which reversed yen carry trades and pushed global liquidity risks upward

From Q3 2015 to early 2016, the S&P 500 index fell by about 10% on two occasions. The first drop was from July 20 to August 25, 2015, with a decline of 12.2%, mainly due to the rising expectations of interest rate hikes in mid-2015 and the rapid decline of Chinese concept stocks and U.S. stocks following the "8.11" exchange rate reform and the depreciation of the Renminbi; the second drop was from November 3, 2015, to February 11, 2016, with a decline of 13.3%. This was triggered by the Federal Reserve's first interest rate hike after the financial crisis, combined with the market's expectations of multiple interest rate hikes by the Federal Reserve in 2016, leading to a significant drop in U.S. stocks until the joint statement by several central banks from China, Europe, and the UK on February 11-13 reversed the downward trend.

IV. Has the U.S. stock market adjusted since the beginning of the year?

(1) This round of adjustment resembles a combination of early and late 2018

This round of adjustment resembles both early 2018 and late 2018. On one hand, this round of U.S. stock market adjustment is a response to the elimination of Risk-on expectations brought about by Trump's policies after he took office, similar to the pullback after the tax reform policy expectations were fulfilled in early 2018. On the other hand, similar to the negative impact of the "tax cut" policy retreating at the end of 2018, the negative effects of the tariff policy on China have become apparent. This round of adjustment is also a repricing of Trump's tariff policy, as there was no transitional period set for the tariff policy, so the U.S. reflected the impact of the increased tariffs on the economy and inflation during the same period.

 Will the expectation of a U.S. economic recession become a reality?

The U.S. stock market has adjusted by about 10% this round, and if a recession in the U.S. is confirmed, the stock market will undoubtedly adjust towards 20%. Of course, according to the peak process seen in 2000, valuations can peak before indices, and indices can peak before fundamentals. But at least it requires valuation factors to continue to be impacted, such as tariffs driving up inflation, prompting the Federal Reserve to take interest rate hikes.

There is a lack of short-term evidence for a U.S. economic recession. The current expectation of a "recession" in the U.S. comes from a sharp decline in the consumer confidence index and a significant downward revision of the GDPNow for Q1 actual GDP annualized rate (as of March 17, it was -2.1%), but more is based on the trade deficit expansion caused by "import rush" (net exports dragged down by -3.3%). In terms of consumption, the negative month-on-month retail growth in January is related to the high base at the end of last year, while February retail data has shown some recovery. Regarding PMI, both manufacturing and non-manufacturing PMIs remain above the expansion-contraction line. In terms of employment, the U.S. unemployment rate is still hovering around a low of 4.0%, and the impact of government layoffs on employment still needs to be observed, with Q2 possibly being a verification window. Aside from the weak real estate and consumer confidence, other economic indicators currently do not show much risk.

(3) What happens after a 10% adjustment? The March FOMC is crucial

What happens after a 10% adjustment? The March FOMC is crucial. Before the Federal Reserve's interest rate meeting in December 2018, the U.S. stock market had also fallen by about 10%, but at the meeting, the Federal Reserve emphasized continued significant interest rate hikes in 2019 and provided guidance for 4 rate hikes, after which the stock market quickly plummetedIf the March interest rate meeting held this week shows hawkish hints, U.S. stocks are likely to replicate the script from December 2018 and continue to decline by 5%-10%.

Looking further ahead, the trend of U.S. stocks will depend on the Federal Reserve and Trump's subsequent policy changes. For the former, there are two scenarios: one is that after a further 10% adjustment in U.S. stocks, the Federal Reserve may signal easing, leading to a halt in the decline of U.S. stocks; the other is if the U.S. experiences a rapid tightening of overnight liquidity similar to the collapse of Silicon Valley Bank in March 2023, then the Federal Reserve could provide liquidity to U.S. stocks through the Bank Term Funding Program, potentially leading to a rebound in U.S. stocks. For the latter, if U.S. stocks continue to adjust without Federal Reserve intervention, and the recent "recession" narrative gives Trump more domestic leverage, we may see the advancement of a new tax reduction bill and deregulation policies in the second quarter. If so, U.S. stocks could also experience a reversal. The scenario we currently lean towards is: the Federal Reserve's statement in March is hawkish, U.S. stocks may still have adjustments in the short term, but in Q2, under the influence of a dovish shift from the Federal Reserve or Trump's policies, new highs may be reached, although pressure will gradually increase thereafter.

(4) The "weak dollar" narrative since the beginning of the year may see a phase reversal in Q2

As mentioned earlier, although we believe that the turning point of the dollar's long cycle may occur within 1-2 years, the probability of a short-term rebound in the dollar index is not low. The dollar's pullback in Q1 stemmed from the narrative of "convergence of advantages" relative to non-dollar currencies and the convergence of tariff premiums. However, in Q2, the aforementioned factors may marginally reverse, leading to the possibility of a rebound in the dollar index. On one hand, the Atlanta Fed's GDPNow model's downward revision of Q1 actual GDP is largely based on the trade deficit expansion caused by "import grabbing," while U.S. consumption and employment remain resilient; on the other hand, starting in April, non-dollar economies will collectively bear the pressure of U.S. tariffs. If reciprocal tariffs are implemented, it would be equivalent to the U.S. imposing an average 10% tariff globally, which could put further pressure on non-dollar exchange rates. If the dollar rebounds, it may also positively influence U.S. stocks in Q2.

Author of this article: Zhang Jingjing, Wang Luobin, Source: China Merchants Macro Insights, Original title: "China Merchants Macro | Has the US stock market adjusted appropriately?"

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