BlogBook

1 September 2015

Best of the Web

Latest Blog

Chinese markets return to Earth

By David Dapice

China’s stock market crash and the international volatility set in motion have again put the world on edge. Analysts vie to predict what comes next.

According to the noted economist Paul Samuelson, the stock market has predicted nine of the last five recessions. His point: There is often little or no relationship between stock prices and the real economy. Even after a stomach-churning week of jagged movements, the US stock market index S&P 500 is 10 per cent below its recent high and up 37 per cent from three years ago.

In China, where the volatility has been higher, the Shanghai index, 2288 a year ago, is above 3100 now, a gain of near 40 per cent — though it dropped 40 per cent from its peak in June.

The volatility signals reassessment of global risks.

Start with China, where the data are poor and the strategy of the economic managers is less clear. China is in a transition from an investment and export-led economy to one based more on consumer spending and services. The economy seems to be slowing more than anticipated. Electricity consumption is flat; industrial production, exports, imports, and car sales are down; and there is evident surplus capacity in most industries and real estate for many cities. Yet GDP growth is said to be 7 per cent. Some analysts say this is possible due to a shift to services which consume less energy, but others express doubt about the data, suggesting lower growth.

It is indisputable that debts are growing much faster than incomes. In 2007, the debt to GDP ratio in China was 158 per cent; by 2014 that ratio had risen to 286 per cent, according to a McKinsey report. Since debt is serviced from income, this trend is ultimately not sustainable.

Yet the Chinese authorities seemed to think that a soaring stock market would create a wealth effect and help consumption. They touted the stock market and made credit easily available to encourage borrowing to buy stocks. Foreigners were less exposed, owning less than 5 per cent of the market. While fewer than 70 million stock accounts were created, with more than 20 million having since left the market, many investors were not sophisticated and of modest means. They bid up the price of Chinese stocks, even when the economy was struggling.

This set up the dramatic decline in prices — a decline that happened even though the government bought stocks, stopped new stock offerings, threatened short sellers, prevented executives from selling stock they owned in their own companies, and aggressively eased monetary policy. These steps work mostly against the reforms promised to make the economy more market oriented.

The seeming impotence of the government has raised questions about competence. Capital outflow, though manageable, was nearly $150 billion in the second quarter. It may well be higher in the current period. The recent effective, if modest, devaluation of the yuan will not improve sentiment.

One interpretation is that the yuan adjustment was sensible and measured, a response to a super-strong dollar to which China had kept a stable relationship until recently. In addition, the letting go of stock prices may have been a recognition that stock prices have to be allowed to fluctuate, even if that damages those who followed the official line. However, many will see chaotic and erratic policy — a suggestion that the world’s leading source of growth is not under control.

In any case, the rich world is not in particularly good shape. Commodity producers like Canada and Australia are under pressure as commodity prices plunge and quantities contract. Prices for copper and oil, often indicators of global economic health, are near multi-year lows. Japan recently had a contraction in its GDP. The European Union is barely growing despite a weak euro. The United States had seemed to be set for 2.5 per cent growth, but a strong dollar and weak foreign demand are putting future growth in doubt and corporate profits under pressure. Prospects of an interest rate rise, all but promised by the Federal Reserve, further increase nervousness.

The US stock market had gone through an extraordinary period of low volatility and steadily increasing prices in the last several years — it had tripled from its post-crash lows. Despite evident problems in corporate profits, the market sailed smoothly on until August. Some had decried the use of borrowed money to buy company stock so that per-share earnings rose even while revenue, investment, R&D, and even total profits declined or were anemic.

None of this seemed to matter until the high-speed algorithms that control so much of the traded volumes decided that it did matter. Or perhaps it was also nervous human traders that wanted to lock in gains in what seemed a market “priced for perfection” — that assumed everything would work out and risk was as low as recent volatility. In any case, there was a breathtaking drop of more than 1000 points in the Dow Industrials index, a fall of 6 per cent or so, in just a few minutes on 24 August. By Friday’s close, the Dow was higher than before its fall, before volatility kicked in once again this week after China’s release of manufacturing data.

There is no doubt that the global economy is not in balance. Much of the developing world had relied on Chinese commodity demand to fuel their exports and overall growth. Russia, Brazil, South Africa, Nigeria, the Gulf States, and much of the rest of Latin America and Africa are under pressure from lower export prices and a strong dollar that makes repayment of dollar debts more burdensome.

While foreign exchange reserves have been built up, this only buys time to adjust. If resource investments plunge while uncertainty holds back consumer spending that might have increased in response to lower raw material prices, there could be an overall lack of global demand. This will create pressures for competitive devaluations and hidden trade barriers. It will also create political instability in many countries and further chill investments. With sluggish or negative growth in much of the rich world and outright contraction in many large developing nations, it’s not surprising that investors and consumers are nervous.

In all of this, the US economy has held up relatively well. Manufacturing is only 15 per cent of GDP, and much of that is not highly sensitive to the strong dollar — refining, aircraft, biotech, and local food processing, for example. The banks are sound, real estate is reasonably priced and consumers have deleveraged debt. Government deficits are modest, and companies have large offshore cash hoards that can be mobilised once lobbyists negotiate another tax amnesty through Congress.

But even the United States cannot be an island of prosperity in a sea of troubles, nor can slow US growth provide enough demand for the rest of the world. US stock prices still look pricey and rising interest rates, even if the Fed is slow in guiding them higher, will create more competition for stocks. Most analysts expect future stock price gains to be muted and volatility to be higher than in recent experience.

In summary, the recent volatility does not mean a great depression or even a significant recession, but it does signal a return to a more historically normal and realistic assessment of the risks in the real economy and to stock prices. For long-term investors, the best advice may be to turn off the television and check your asset allocation.


This post was originally published at YaleGlobal

2 September 2015