In the West, equity markets are among the world’s most accurate leading economic indicators. Cycle shifts in stocks and bonds often foretell upcoming shifts in the economy. In open, liquid markets, the bear without recession (prolonged drop exceeding -20%) isn’t unprecedented [i], but it is rare.
Most Western pundits and analysts seem to be viewing China through this lens lately. China’s domestic markets have sold off sharply since June 12, with the Shanghai Composite falling over -30% at its lowest point, spurring many fears the long-rumored-yet-rarely-seen hard landing was fast approaching. These fears were heightened by China’s government outright intervening in the stock market, seemingly lending credence to the notion that the real economy faced a threat. Next, enter a contractionary 47.8 read in July’s Caixin/Markit Manufacturing Purchasing Managers’ Index and an -8.3% y/y drop in July exports. When the government followed this by devaluing China’s renminbi, many claimed China’s government was desperate to stop the economic bleeding. However, China’s domestic equity markets aren’t a reliable leading indicator of economic activity, and recent data—and even government behavior—seem in line with longstanding trends, not a sharp downturn.
China’s domestic equity markets simply aren’t liquid or open enough to function as a reliable forward indicator. The gauges most cite—the Shanghai Composite Index and its younger sister index, the Shenzhen—list A-shares, a class largely restricted to domestic Chinese investors. They have a very wild history, bearing little resemblance to global market trends or the domestic economy. Exhibit 1 shows the last twenty years of this wild history, with prolonged -20% peak-to-trough moves highlighted.
Exhibit 1: Shanghai’s Stocks—the Wild, Wild East
Source: FactSet, as of 8/12/2015. Shanghai Composite Index Price Level, 8/11/1995 – 8/11/2015. MSCI World Index price level denominated in Chinese yuan.[ii]
There are nine -20% or greater moves depicted here, prior to the current one. During the 20 years shown, there are only two global bear markets. China’s wild ride doesn’t ripple globally.
Nor does it ripple into China’s economy. Exhibit 2 shows the Shanghai index with bear markets depicted in orange. The gray columns are Chinese year-over-year GDP growth rates.
Exhibit 2: The Shanghai Isn’t a Reliable Leading Indicator for China’s Economy
Source: FactSet, as of 8/12/2015.[iii]
Now, a typical objection from a Westerner might be that stocks drop before the economy weakens. Yet, take a close look at Exhibit 2. From 2001 – 2005, the Shanghai had two -40% drops while GDP growth overall accelerated from about 7% to over 10%. The 2009-2010 drop occurred while Chinese growth surged in the wake of the global financial crisis. During the entire 20-year period depicted, the slowest China grew was 6.6% y/y, in Q1 2009 (the apex of the global financial crisis). China’s market cycles bear little relationship to its economy, much less the global economy. The market is too thinly traded by too many investors armed with suspect information. There is little reason to think it can rationally reflect expectations of future economic activity.
But what of that Caixin/Markit Manufacturing PMI and the falling exports? While neither of these gauges are particularly robust, it is critical to assess data in light of the trend, not in isolation.
PMIs measure the breadth of growth—not magnitude. There are surveys of many firms tallying the percentage reporting business is growing versus contracting. Hence, readings above 50 are considered expansionary.[iv] The Caixin/Markit gauge is one published by economic data firm Markit. Here is the trend in the aforementioned Manufacturing gauge—and the trend in Caixin/Markit’s Services gauge, too. Manufacturing has long bounced along the divide between growth and contraction. This isn’t new. Meanwhile, China’s largest industry—Services—is consistently above 50. July’s read, in fact, was up from June’s.
Exhibit 3: Caixin/Markit China Manufacturing and Services PMIs
Source: Bloomberg, as of 8/12/2015.
What’s more, Caixin/Markit is only one attempt to measure growth—and one that downplays China’s large, state-owned enterprises. The official China PMI Manufacturing and Services gauges show similar trends, although neither are below 50.
Exhibit 4: Official China Manufacturing and Non-Manufacturing PMIs
Source: FactSet and the National Statistics Bureau of China, as of 8/12/2015. August 2012 through July 2015.
It’s also true export growth has weakened. However, some perspective here is in order. Through 2015’s first seven months, exports are down -0.6% versus the same period in 2014. That’s it! And all this is occurring in a (largely) command economy that the government has openly announced will shift from a credit-driven infrastructure development and export-heavy strategy to a services- and domestic consumption-driven model. This isn’t a secret, it has long been the government’s official stance. So it shouldn’t come as a shock manufacturing and export gauges aren’t skyrocketing.
Finally, those government actions. China’s government has also long said it planned to liberalize its financial system, gradually opening it to more market forces. This is a work in progress, and reform in China frequently comes in fits and starts. Clearly, intervening directly in equity markets isn’t a very market-oriented liberalization. But the one that has stirred up so many this week—allowing the yuan to float a bit more—largely is. It’s a baby step, and no one is claiming the yuan is all of a sudden as free as Western currencies. But the move seems in line with the reforms’ spirit.
For all the headlines proclaiming China is in desperation mode, attempting to “steal” growth from the West via a cheaper currency, there is actually no real sign that’s necessary or underway. Now, that could change, and it is worth watching Chinese data and those of its major developed-world trading partners. This is, after all, the world’s second biggest economy. But at this juncture, there is little actual evidence anything has materially changed in China except the domestic equity market cycle. And, unlike Western equity markets, that doesn’t tell you much of anything.
By Todd Bliman, Fisher Investments
[ii]In case you were wondering, the fact the MSCI World is depicted here in Chinese yuan is why the index isn’t beyond its 2007 level. In USD, it has set numerous record highs in this cycle.
[iii]We were tempted to color the bear markets green and the bulls red, because in China, green stock tickers and numbers means down and red means up. Seem backwards? Well, they’re communists, remember.
[iv]Since the gauge doesn’t measure magnitude, a reading close to 50 may not tell you much of anything about growth, because fewer than 50 firms could be growing at gangbusters rates, driving the whole economy to grow. And vice versa.
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