Stocks could keep falling, here's why

It’s been an ugly holiday week so far for stocks erasing annual gains for the major averages after investors continue to unload what had been market leaders: large cap tech.

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Since record closes in September, both the Dow Jones Industrial Average and the S&P 500 have tumbled quickly and are flirting with correction territory, or a 10% drop from recent highs, while the tech-heavy Nasdaq is already in a correction and not too far from a bear market.

Still, there is a broader negative narrative driving the market lower, fueled by expectations for declining corporate earnings growth and concerns about slowing economic growth, despite a strong job market and data that supports further economic expansion. Investors are also nervous about Federal Reserve interest rate hikes, trade negotiations with China, a bumpy Brexit and the outlook that 2019 will be politically contentious in the U.S. with no new stimulus coming.

Craig Johnson, chief market technician for Piper Jaffray, thinks the market is in the beginning stages of a washout. He says it typically takes nearly nine-and-a-half weeks to rebound from that type of market drop.

“The shake out isn’t done yet…Santa is not coming this year kids,” Johnson said of the typical year-end so-called Santa Claus rally that typically happens around the holidays. “But I don’t think the secular bull market is over.” Johnson says the S&P 500 would need to break below a level of 2500 to 2580 for the bull market to be in question from a technical standpoint. That would be about a 5.6 percent pullback from current levels.

FOX Business takes a deeper look at the top headwinds for U.S. stocks.

U.S.-China negotiations on trade

Investors are watching U.S. trade negotiations with China with a close eye on President Trump’s meeting with Chinese President Xi at the G20 in Buenos Aires at the end of the month. Jitters over trade have resurfaced after the U.S. and China clashed over trade last weekend at the Asia-Pacific Economic Cooperation summit, casting doubt over whether Washington and Beijing can at least get a trade cease-fire at the G20. As FOX Business reports, President Trump and his top advisors including Larry Kudlow are keeping the pressue on the Chinese to make a deal that benefits America.

BREXIT

Britain is due to leave the European Union at the end of next March, regardless of whether or not there is a deal. EU Article 50 provides automatic withdrawal by that date unless a unanimous agreement is made to extend the timetable. If no deal is made, a complicated and disorderly process would ensue. Investors are growing weary a deal will be made.

Earlier this month, British and EU officials reached a draft agreement on Brexit. Britain’s Prime Minister Theresa May was able to get her cabinet to approve the deal. But the deal has led to resignations by British ministers, including the Brexit minister, and numerous objections by the UK parliament, which must ratify the deal.

May’s Conservative Party doesn’t have a majority in the House of Commons and the lawmakers in her party oppose her plans to leave the EU. May will be forced to rely on votes from members of the British Parliament who don’t support her and don’t want to leave the EU. Her plan closely ties the U.K. to the EU for years after it formally quits the bloc, which could hurt Britain’s ability to negotiate trade deals with other countries and gives the EU the final word on a hard border in Ireland.

“Bank of England Chief Mark Carney better hope the transition goes smoothly because he's got nothing on his end in dealing with any negative economic fallout,” said Peter Boockvar, chief investment officer for Bleakley Advisory Group.

Corporate debt ballooning stokes default fears

Banks were up to their ears in debt leading up to the financial crisis and when the economy went south the banks did too. Now investors are closely watching for high debt levels in individual companies, such as battered General Electric, that have been on a borrowing spree fueled by cheap money.

“The canary in the coal mine this business cycle it will be a corporate default,” said Joe LaVorgna, Chief Economist for Natixis. “It will be someone not meeting an interest payment when someone thought they would. That in turn could hurt confidence, which could depress growth.”

LaVorgna thinks a default could take the form of a large firm in an emerging market that issued a lot of dollar-denominated debt that perhaps didn’t hedge it properly.

In the U.S., worries are rising about GE bonds being downgraded to the lowest rating of “junk” from its current investment-grade status. If a downgrade of GE’s bonds occurred, it would increase the supply of so-called high yield bonds, or junk bonds, making it harder for investors to buy up the new bonds. Further, many pension funds cannot own junk bonds and would be forced to sell GE bonds, which could cause ripple effects.  Yields on junk bonds could rise further, making it more expensive for firms to finance their debt and could lead to defaults. The Federal Reserve is watching corporate debt closely. Right now, the credit-rating agencies say that if GE’s restructuring goes as expected, there won’t be a need to downgrade.

The Federal Reserve

The Federal Reserve has penciled in one more interest rate hike this year and three more next year. Investors are fearful growth will slow next year as effects from the Trump administration’s tax cut peter out and a massive government spending package wanes, causing the central bank to raise rates too much, hurting the economy. “As we have been warning for quite some time, an ever tightening monetary policy poses the greatest risk to financial markets and hence the broader economy,” says Lavorgna.

Fed Chair Jay Powell said in an interview this fall that the Fed is still “a long way” from neutral and that the Fed could go past neutral, touching off the current downdraft in stocks. Officials are aiming to get the benchmark interest rate to a level of neutral, which neither speeds up nor slows down economic growth.

Minutes from the Fed’s policy meeting in September showed a “number” of members want to raise interest rates faster in the short term to make sure inflation doesn’t take off well beyond their 2% target. Powell didn’t stray from the Fed’s course for further gradual rate hikes when he spoke for the first time since the November policy meeting last week, noting that he thought the economy could continue to chug along. Though, the Fed’s current economic forecast projects growth to slow next year to 2.5% from 3.1% this year, before slowing further in 2020 to 2%. Next week, Powell speaks in New York and investors will get the next round of minutes, which could reveal a better window into how officials feel about the economy and the path for interest rate increases.

“Stocks are breaking down, you’re on a collision course with the Fed hiking, and tough comparisons in terms of earnings estimates slowing,” says Johnson. “Until we figure out that the Fed tightening cycle is over, I think it will be a more challenging environment for stocks.”