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This is why stocks are stuck in low gear

A big downdraft in commodities is weighing on stocks and feeding fears of global deflation.

Shares in the U.S. and Europe fell sharply Tuesday, as the chill of China's economic slowdown rippled through world markets. Copper, oil, silver and platinum were down during the afternoon, prompting stock traders to sell miners and materials companies on worries the declines could continue.

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Earlier in the day, the Asian Development Bank trimmed its 2015 forecast for Chinese growth to 6.8 percent from 7.2 percent, and said lower demand from China will affect growth rates in developing Asia through reduced trade and lower commodity prices. Credit Suisse on Tuesday cut its outlook for Chinese demand as well as commodities prices and mining stocks. Mining names weakened, and Glencore, for instance, was down as much as 10 percent.

Copper production in Johor, Malaysia
Munshi Ahmed | Bloomberg | Getty Images
Copper production in Johor, Malaysia

The S&P 500 slumped 1.2 percent, falling to 1,942. A number of analysts say it could soon retest its August low of 1,867. There are 200 stocks in the S&P 500 that are in bear market territory, or more than 20 percent off their highs. Among the 200 are 35 energy companies and 17 materials names.

"This latest leg down (in commodities) seems to be about demand," said Marc Chandler, chief currency strategist at Brown Brothers Harriman. Chandler said the selloff is the result of the Fed's focus on China at its rates meeting last week and downward revisions for Chinese growth and demand.

"At the beginning of this year, China was 10 feet tall. The swing in sentiment toward China has been so dramatic," he said. "China never really was 10 feet tall but it's not going to fall off the face of the Earth either."

Chinese President Xi Jinping is visiting the U.S. and traders are looking to him to make some clarifying comments on the Chinese economy and its policy. Xi speaks Tuesday night to business leaders in Seattle, and then with President Barack Obama on Thursday.

The Credit Suisse analysts wrote that China's outsized investment in infrastructure needs to decline by 30 to 50 percent over the next five years, and that will have negative impact on demand for commodities like iron ore, coal and zinc. They said that copper needs more curtailments in production and that will send prices lower.

"There is little to like about most commodities over the medium term, just relative degrees of unloveliness," the Credit Suisse analysts wrote. They noted, "Until China demand and emerging market currencies hit a floor, it will remain challenging to put an absolute floor on commodity prices."

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Wall Street strategists are quick to note that the China slowdown story is nothing new but the market's obsession with it is, especially now that the Fed identified China as a cause of concern for even the domestic U.S. economy. The U.S. central bank noted its concerns about international developments and it also chopped its own growth and inflation forecasts when it held off hiking rates last week. The Fed now sees inflation this year at 0.4 percent, from 0.7 percent.

The Fed has targeted 2 percent inflation and has said it expects to get there. But the selloff in commodities has made it difficult for markets to expect inflation to pick up.

"I'm not even convinced it's just China," said James Paulsen, chief investment strategist at Wells Capital Management. "I think it's that the market can no longer trade at 19 times earnings ... I think this is a market in search of a new level that can handle lower earnings growth, higher interest rates and some margin pressures."

While Credit Suisse sees a shallow recovery in some metals, it expects iron ore to see the most decline.

Paulsen said it appears that commodities may be bottoming, and lower commodities prices should be a tail wind ultimately for stocks. But he also expects the stock market to continue lower.

"I think we're going to maybe break 1,800 (on the S&P) and have sheer panic, and then find a bottom," he said.

Barclays on Tuesday also trimmed its expectations for Chinese growth, cutting it to 5.3 percent in the third quarter and 5.5 percent in the fourth quarter. China GDP grew by 7 percent in the second quarter.

The Chinese slowdown is not expected to land a direct hit on the U.S. economy, but emerging markets could be a transmission point, as demand in those markets drops off and the pressure on the U.S. economy comes via trade.

JPMorgan economists in a report said a 1 percent GDP shock in China equates to a half-point drag on global growth. The hit to emerging markets is one for one, but the drag on developed markets is more like 0.2 percent, according to JPMorgan.