The fundamental issue confronting investors is about supply and demand.  In recent weeks, as energy prices and other industrial commodity prices fell, investors focused on supply. The stimulative effect of the fall in prices, and the likely policy response by some major central banks, such as the ECB, and possibly the BOJ. This was good for equity markets and weighed on the euro and yen. 

However, this changed abruptly last week. Several developments took place that shifted the focus to the weakness of demand. OPEC and IEA cut their forecasts for oil demand next year. China reported an unexpectedly large fall in imports and slower real sector performance. Meanwhile, reports suggest China may reduce its growth target next year from 7.5% to 7.0%. This follows on the heels of the recent cut in the ECB's GDP projections for the euro zone. The Bundesbank also halved its German growth forecasts.

Ultimately, we suspect the second narrative is not as compelling as the first. The downward revisions of demand were already foretold by the IMF and OECD, which had cut their world growth forecasts weeks ago. A slowing of the Chinese economy has also been widely recognized.  It is hardly new news. 

The same can is true of the ECB staff's new GDP forecasts. Is sluggish growth really surprising under the tutelage of order-liberal austerity?  Moreover, we note that these new forecasts did not include the growth (or impact on prices) of a significant decline in oil prices since the OPEC meeting. Growth projections will likely be raised if the decline in energy prices is sustained. 

Given the magnitude of the equity markets advance and euro and yen declines since the last swoon in the first half of October, a technical correction might not have needed much of a spark in the first place. Year-end portfolio adjustments, realizing some winners, perhaps to offset some losses, as in the energy patch. As violent as the price action has been in recent days, the fundamental theme of divergence remains intact. Even if these counter-trend moves cannot always be anticipated, they should be incorporated into investors' strategies.  Assuming one's understanding the primary drivers has not changed, these setbacks offer important opportunities. 

II

The key event next week is the federal reserve's last meeting of the year. It will include updated macroeconomic forecasts, and be followed by a Yellen press conference. As the Federal Reserve has done in the past, it should be expected to look largely past the deflationary implications of the decline in energy prices, and the short-run volatility in the equity market.