A Stock Market Crash With Chinese Characteristics

By Nathaniel Taplin

Change from a year earlier. Stocks look more aligned with fundamentals this time
*For all A-shares.

Source: Factset, Wind Info, CEIC

One might think that a “socialist market economy” would feature markets that are less prone to booms and busts than the U.S. Not exactly.

As longtime China watchers know, the country’s still-immature markets are in many ways more bubble-prone than their Western counterparts, thanks to heavy involvement from retail investors who often take cues from government policy, rather than quaint notions like earnings. Tanking Chinese stocks—the Shanghai Composite is now down nearly 25% from its January peak—could therefore be taken as a meaningless signal. That would be a mistake: this year’s selloff reflects real worries about Chinese growth and financial stability. 
The slowdown is still at an early stage, but is poised to deepen in the second half—adding to headwinds for global stocks that are already under assault from rising trade tensions.

The last time Chinese stocks popped, in early 2015, was a classic example of Chinese market dysfunction. Corporate earnings and the economy were faltering, but the central bank was aggressively pushing down borrowing costs: retail investors took this as a green light to make massive leveraged stock bets, helping the Shanghai Composite to double in six months. When rules on margin borrowing were tightened in mid-2015—and everyone suddenly remembered that the real economy was still in the doldrums—most of those gains evaporated.

Change from a year earlier

*Average of change in metals, power, steel, cement and glass output.
Source: CEIC

The bull market in Chinese stocks, which started in 2016, had better fundamental economic support—but that support is now eroding. While services still look healthy, industrial profit growth peaked in the third quarter of 2017. A spring bump in investment and industrial output, thanks to the end of winter pollution controls, looks unlikely to last—since 2014, property investment has never risen faster than overall credit growth, which is now slowing sharply. Exceptionally weak May credit and investment data was one trigger for the current selloff.

Exports are also under pressure, even before President Donald Trump’s tariffs have really hit. Weakening export momentum is one reason the yuan, now down 3% against the U.S. dollar since the end of May, has sold off so sharply in recent weeks. Both China’s official purchasing managers index and Caixin’s privately compiled index showed export orders declining in June—the first simultaneous contraction since October 2016. The yuan’s abrupt weakening also risks renewed capital outflows at a time when the Federal Reserve is in full tightening mode.

     An investor watches stock prices at a brokerage in Beijing on July 6. Photo: Reuters 

That all sounds rather worrisome—but the downturn this market drop is signaling might not be as ugly as the last in 2015, when housing prices dipped sharply and steel firms defaulted in droves. China’s enormous housing inventory overhang has dropped by about a third since early 2015. And Beijing also imposed tough new controls on capital exiting the country following the market mayhem of that year. More cash trapped in China chasing fewer empty houses raises the probability of a less severe Chinese housing downturn this time around.

Still—if housing prices do start falling rapidly, or if a lot of capital starts finding ways out through the cracks, investors should prepare for stormy weather. China’s central bank has begun intervening in onshore markets again to support the yuan. If large-scale intervention continues, the resulting pressure on domestic money supply could trip up China’s heavily indebted developers and industrial firms, or cause funding difficulties for smaller banks. Recent moves to lower borrowing costs—and reports that tighter rules on bank wealth management products have been delayed—hint that some policy makers are getting nervous that China’s “deleveraging” campaign risks going too far.

A stock market crash—so far much smaller than in 2015—is something China can likely handle. More ructions in its fixed income and currency markets, this time with the Fed deep into its tightening cycle and little relief in sight, would be far more worrisome.

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