Since a global stock market correction began to unfold about two weeks ago, financial headlines have brought forward a number of causes -- seasonal weakness, fears surrounding the impending Fed rate rise, and particularly, fears surrounding China. Although the Shanghai Composite Index peaked back in June, mid-August saw the index take another dizzying slide -- 26.7 percent in eight trading days. A raft of measures from the Chinese government failed to stanch the bleeding; a weak rally occurred, and was followed by a decline. As of this writing, the Shanghai market is down on the year, after having been up 59.7 percent at its June peak.
(We note that the Shanghai market has now retraced about 65 percent of its total move from mid-July of 2014 to the peak in June of this year.)
However, as our readers know, the Chinese stock market -- unlike most other stock markets -- does not trade on fundamentals; it trades almost purely on psychology. Therefore it can have, and often has had, violent moves without radical changes in the underlying economic reality. The following chart shows GDP growth per annum, and compares it to the actual movements in the Shanghai stock exchange. Note that GDP has risen steadily, although at differing rates, from 1991 to the present. Even during the big market setbacks and recessions experienced by the rest of the world from 2007 to early 2009, China grew, and it is still growing today. The market, however was a different story. It fell at many times from 2001 to 2005 while annual GDP growth averaged about 10 percent. The market also fell from 2007 to early 2009, and from 2010 through mid-2014, while annual growth probably averaged 8 percent.
This has also meant that steep declines and rallies in Chinese stocks have not historically had a strong influence on other global stock markets. Aside from high-correlation events such as the global financial crisis, the markets are uncorrelated. The long-term chart below compares the performance of the S&P 500 with the Shanghai Composite since 1991. Note that the U.S. market has outperformed the Chinese market for the last 15 years; if adjusted for the Chinese Yuan’s appreciation against the U.S. Dollar, returns are the same for both markets.
Does that red oval at the right of the graph really indicate the beginning of a new correlation? No. So then why are global markets being roiled by a Chinese market decline?
The answer is that the Chinese market decline is being interpreted in another framework: an ongoing narrative about Chinese economic collapse. The Chinese stock market “collapse” is, according to this view, a consequence of an impending, long-feared Chinese economic “hard landing” -- the catastrophic end of China’s multi-decade growth trajectory, which will (according to pundits’ fears) unleash a wave of global deflation as China’s ravenous appetite for commodities evaporates. Never mind that, as we noted above, Chinese markets and Chinese economic fundamentals are not correlated at all.
As we write, for example, headlines “explaining” Tuesday’s weakness in U.S. stock markets are focused on the announcement of Chinese PMI numbers. The PMI (purchasing managers’ index) is a broad measurement of an economy’s health, including new orders, inventory levels, production, supplier deliveries and the employment environment. It focuses on data about raw materials and manufacturing and has little correlation to changes in the retail and services sectors of the Chinese economy. Anything under 50 represents a contraction; the reading came in at 49.7.
Call us crazy, but there is nothing in this chart that looks like a collapse. (You can see what a real collapse looks like by looking at the PMI indices in 2008.) We see a PMI number that’s about where it’s been for four years.
The same is true for many of the Chinese data we monitor. The data confirm our big-picture view of the Chinese economy:
First, Chinese growth is not collapsing; on a secular basis, it’s moderating, and in the nearer term, it’s suffering from a decline in developed-market demand -- like all the rest of the emerging-market exporters. In short, China is not its own immediate problem -- anemic developed-market demand, and anemic developed-market growth, is the problem with China’s exports. The same problem faces all emerging-market economies, which are obviously export-driven. Developed markets, on the other hand, are not primarily export driven; exports have an influence, but it is substantially smaller than the influence in emerging markets. That’s cyclical, not structural. Our best estimates suggest that China’s economy is growing at about 5 percent per year -- not 7 percent as official statistics indicate, but a far cry from recession. Currently the U.S. economy is growing slightly in excess of 2 percent per annum.
That moderating growth also indicates the normal maturation of the Chinese economy, and the shift of its growth engine from infrastructure and industry to the domestic consumer -- an ongoing process we’ve been pointing out for years. Less exciting industrial numbers miss the continued health and growth of the Chinese consumer sector.
Second, China is not engaged in a currency war. As we have noted before, the recent “devaluation” of the Chinese currency is a blip compared to the Yuan’s long-term appreciation. China has not devalued; the most that can be said is that it has moderated the pace at which its currency has appreciated. China’s injections of liquidity into its banking system are also not extraordinary.
A Note on Chinese Monetary Interventions
Speaking very simply, in a growing economy, the money supply needs to grow. That’s the core problem with pure gold standard regimes -- the money supply can grow only as fast as gold can be mined. If money supply growth isn’t keeping pace with economic growth, deflation will be the result -- and that acts as a drag on expanding economic activity. (That’s why pure gold standards that functioned reasonably well in pre-industrial economies started to break down in the 19th century, when dynamic industrial growth took off.)
So all the world’s major central banks influence the growth of the base money supply through a variety of mechanisms: purchasing foreign currencies, purchasing assets from commercial banks, controlling reserve ratio requirements, and so on. China’s preferred mechanism is shifting along with shifts in the size and growth of the country’s foreign exchange reserves. The government is still effectively managing an appropriate growth of the base money supply -- just like the developed world’s central banks. So what’s happening with the alleged “extraordinary liquidity injections” by the People’s Bank of China (PBOC)? Answer: not much -- it is just another central bank navigating economic vicissitudes and keeping an even keel.
To sum up, we view current fears about Chinese stock markets and the Chinese economy as an irrational panic. With U.S. economic fundamentals continuing to strengthen, we can’t help but view the current correction in U.S. stock markets as pointing to a buying opportunity in high-quality names as they return to more attractive valuations. We have repeatedly explained in these pages that we expected the correction to take place in the historically vulnerable September-to-October time frame. This year, the correction has started a little earlier, in August, but it is still the expected correction. We have a shopping list up-to-date, and we are looking for opportunities to buy as bargains appear.
Are There Problems Ahead For China?
Yes, there are.
First and foremost, China’s leadership is managing an all-out effort to root out endemic corruption. While Xi Jinping has seen some success in this endeavor, he has far to go, and we suspect he will meet even stiffer opposition from powerful opponents. We hesitate to speculate on the form that resistance will take, but we would not be surprised to see significant attempts to discredit him and thwart his reform efforts. This struggle could act as a drag on China’s growth.
Second, China’s long economic boom has resulted in large debt growth. (The growth of debt usually has a tendency to outrun the potential growth of the economy that underlies it, and cleansing financial crises often occur when the discrepancy between optimistic growth projections and less extravagant growth realities comes to light.) Much of that debt exists in the unofficial, or shadow banking sector, where it’s hard to account for or to analyze. We don’t see the shadow banking system imploding today, but ultimately if that debt grows and if it is not managed effectively by the Chinese government, it may result in financial instability or an internal financial crisis. As we have often noted, we believe the PBOC currently has the firepower to contain such a crisis. However, its effects would be unpredictable and certainly negative for global investment psychology.
Investment implications: Panic over Chinese stock markets and the Chinese economy is not rational. Over the past 25 years, there is no identifiable historical correlation between the Chinese stock market and the Chinese economy. Currently, we see no indication that the Chinese economy is crashing. In China, we see a maturing economy navigating a transition from infrastructure and industrial-led growth to consumer-led growth, still growing strongly but at a moderating pace. We also see a country navigating a social and political struggle as its rulers act to root out corruption. What we do not see is any reason to believe that political, financial, and market events in China will derail strengthening fundamentals in the U.S. We understand that psychology is dominant at this stage, and positive fundamentals can’t overcome bad psychology. However, the reality of positive fundamentals means that negative psychology can turn on a dime when the time comes.
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