Fragile China

Monday 08/31/15

     Last week was a turbulent week for stocks, particularly last Monday. Nasdaq futures were halted 3 times Monday morning, shown in figure 1. If you listened to the financial media you probably heard one of two explanations for the selloff in the market.

Narrative 1: A slowdown in China is to blame.

Narrative 2: Who knows? Don't try to time the market because it moves randomly, also you should buy stocks now because they're cheap.

Narrative 1 is mostly wrong because China has been slowing for a very long time. Why did everyone suddenly start worrying about China Monday morning? Narrative 2 is a strange contradiction because it first suggests that one cannot time the market and then goes on to advocate market timing. I do not think the market moves randomly, I believe that it often appears random because the system is so massively complex. This week I want to isolate some of the reasons why China was blamed for the recent turmoil.

China

    If you are a regular reader of my newsletter you probably know that I am not a big fan of investing in China. I guessed that China would enter a massive bubble and that it would deflate all within the year in my 2015 predictions post. The reason for this prediction was that money would flow into Chinese equities (stocks) after the Hong Kong-Shanghai stock connect program. This would lead to speculation in the Chinese financial markets. I also know from previous movements of this type in China that they tend to reverse suddenly and spectacularly in a relatively short period of time. However, even though China's economy is very important, its stock market is relatively small and unimportant to the United States.

    The more concerning aspect about China was the government response. The Chinese government had encouraged speculation and margin financing while they were inflating the bubble and now that it has collapsed they appear to be panicking. China has banned short selling (the practice of borrowing shares to profit from a decline in price). They have also arrested journalists who reported negatively on the markets as well as traders and brokers. China has even gone so far as directly buying stocks in an attempt to prop up its falling market, historically this always fails. The response from the government reeks of desperation and market participants know that. However, the Chinese market has been crashing for a while as seen in figure 2, so what changed last week?

Quantitative Tightening

    As China's economy has slowed, they have been forced to sell U.S. Government bonds in order to keep their economy afloat. This selling of bonds is essentially the opposite of quantitative easing. Instead of the Fed buying bonds, China is selling. In previous rounds of quantitative easing, stocks went up while bonds went down; I suspect this misunderstood relationship will be misunderstood in the opposite way this time around, that is, many will predict a collapse in U.S. treasuries when in fact they will likely strengthen. However, I am not entirely certain that this will be the case exactly, because money may also flow into the United States as it flows out of China.

    China is also swapping bonds with overly extended local governments in an attempt to lower their interest burden. After 2008, local governments in China began taking on unprecedented amounts of debt to stimulate growth. Much of that growth was lost to corruption or misspent on ridiculous projects such as their ghost cities. It worked for a while, but now that growth is slowing again they are stuck with the same problem except this time they have a lot more debt. This practice is similar to that of Japan in the 1970's and 80's as well as the Soviet Union in the 60s, and yes both times there were calls for those countries to overtake the U.S. by such and such a date...they didn't.

Devaluation

    China also devalued the yuan in early August. Unlike most other major currencies, China's currency is set by the Government, meaning it can be whatever they want it to be. If they peg their currency too strong it will slow exports. In an attempt to be more competitive globally they devalued their currency suddenly as shown in figure 3. This can be a problem for profits of multinationals in China, because they report profits in U.S. dollars, so a less valuable yuan means less dollar denominated profits from Chinese operations. This will no doubt show up in next quarter's earnings. This is why I still prefer smaller U.S. based companies with less exposure to China.

Conclusion

    One of the biggest problems facing China is the change in perception. Investors are starting to view China less as a global powerhouse and more as a poorly managed, corrupt, authoritarian quasi-communism. The explosion in Tianjin, overwhelming pollution and other health and safety disasters are also eating away at their credibility. I think fear of China will decline even more as it becomes more and more apparent how fragile their economy really is. My hope is that turmoil in China will lead to a less oppressive regime that embraces freedom for markets and more importantly individuals.