Special Report on China

The Chinese stock market is no place for the faint of heart. This morning we awoke to the news that the Shanghai Composite index fell 8.5% overnight – it’s biggest drop in nearly eight years – bringing the total drop to about 28% from the recent high in mid-June. The impetus for last night’s sell-off, which followed three straight weeks of strong gains, appeared to be two-fold. First, it was reported that profits at Chinese industrial firms dropped in June following two months of growth. Second, the International Monetary Fund (IMF) urged Chinese authorities to reduce the measures implemented to support stocks in recent weeks.

China’s National Bureau of Statistics disclosed that Industrial Profits in June fell 0.3% YOY, which was worse than expected. While a decline is certainly not a good thing, the bigger issue is the reliability of the data coming out of the country. Generally speaking, there is a big disconnect between the government-reported economic data and those reported by non-government sources. In other words, many believe the government data cannot be relied upon. When the government says the economy grew 7% in the first half of 2015, which happens to be exactly in line with the government’s target, many feel the actual growth is much lower. The same can be said for any other of the government statistics. Aside from the obvious negative effects stemming from a lack of trust, this lack of transparency will also have the effect of increasing volatility in the capital markets. This is especially true when the gaps widen between what the government is saying and what independent sources are saying.

The second issue weighing on Chinese stocks is the fact that the IMF asked the government to relax the unorthodox measures that have recently been implemented to support stock prices. The measures included restrictions on selling, purchases of stocks by the state, caps on daily losses, and the halting of a huge amount of individual stocks traded on the exchange. These measures are obviously one reason why liquidity in the Chinese market has fallen sharply. Ironically, less liquidity inevitably results in more volatility. In any case, the perception that the government will offer less downside protection for investors is taking a toll on confidence in the stock market. However, as of mid-day on Monday, the cavalry appears to be riding to the rescue. CNBC was reporting that the Chinese government has decided to increase its stock purchases in an effort to support the market. What a shocker!

The problems we are now seeing in China are the inevitable result of an economy that had grown too fast and at any cost. For many years, the Chinese have consumed massive amounts of the world’s resources to build out its infrastructure. As Chinese demand for a wide range of commodities surged (metals, energy, agricultural products, construction materials, etc), the world ramped up its production of commodities in order to meet the Chinese demand. Recently, however, it has become clear that growth in the Chinese economy is slowing. As a result, there is a significant amount of excess capacity in the commodity markets. To exacerbate the commodity pressures, better technology has resulted in new ways to extract oil & gas from the ground. So we have seen a crash in commodity prices, especially energy, which obviously can have profound implications for individual commodity-dependent economies (Australia, for example) and companies across the globe.

As noted above, there is limited transparency with regard to the Chinese economy. Unfortunately, the lack of transparency spills over into the amount of debt in the Chinese economy as well. While federal government debt may still appear to be at reasonable levels, there is a lot of local and regional debt that is much harder to gauge. Huge amounts of debt have been incurred to develop infrastructure in new cities that, as of now, have very few inhabitants. Many believe that China has a property bubble as well as a bubble in local government debt. Without better information, there will be speculation about worst-case scenarios. Fears about debt bubbles can obviously have spillover effects on the global capital markets.

There are many ways that the Chinese volatility can spill over to other markets. Most obviously, we are seeing the effects on commodity producers across the globe. Companies operating in the Energy and Materials sectors are seeing their stocks get battered as demand for commodities recedes. Moreover, the fear-induced strength in the dollar is really hurting US multinational companies, especially those companies with exposure to commodities. And while commodities producers are the most exposed to slowing growth in China, the deceleration is starting to impact companies in a wide variety of industries outside of the pure commodity companies: construction, infrastructure, autos, technology, healthcare, restaurants, consumer goods. Basically, if you do business in China, your company will be affected. And though the exposure to China may be small for any given company, a big percentage of growth for many companies has come from China in recent years. On the fixed income side, there has also been heightened volatility in funds that invest in emerging market debt, including Chinese debt.

There is little doubt that China is a much bigger risk right now than Greece ever was. And the scary thing is that the Chinese stock market is still up nearly 90% in the past couple of years despite the 28% drop from recent highs. It is true that exports to China represent only a very small amount of US GDP (I’ve seen an estimate of 1%, but don’t quote me on that). But there are numerous ancillary, indirect effects when the major driver of global growth starts to slow. And while fears right now may be overblown based on the government’s support mechanisms, the actual risks to global growth rates is very real.

Peace,

Michael