Don’t Panic Over China: A Financial Outlook on the Chinese Economy

March 3, 2016


Don’t Panic Over China: A Financial Outlook on the Chinese Economy | Clay Northam

On January 4, 2016, the Dow Jones Industrial average closed down 276 points, the worst year-opening trading day in eight years. It was followed by seven more triple-digit declines, pushing the index down by 5.5% for the month, and into an official 10% correction off its 2015 high. The benchmark S&P 500 didn’t do much better: off 5.1% for the month and down 8.9% from its relative high. Meanwhile, small cap stocks had fallen by month-end into a full-fledge bear market, with the Russell 2000 down 20% from June 2015’s high.

And where were the fingers being pointed? Falling oil prices and China. China whose equity benchmark Shanghai Composite Index shed 22.2% in January, completing a nose dive of 47.0% from its 2015 high watermark. More pointedly, the story was that the Chinese economy, the engine for world growth since at least the late 1990s, was cooling even more than officials were willing to document, that its manufacturing sector is plagued by overcapacity, its real estate market in a bubble, and that it was only matter of time before its banks collapsed under the weight of a rising number of non-performing loans.

If that sounds familiar, it should because it echoes what happened in the US on the eve of the Great Recession. And although the US economy continues to chug along, albeit at a sub-par rate of growth, what happened here eight or nine years ago haunts investors. China’s woes have already contributed to recessions in several developing markets, most notably South Africa, for whom China represents its biggest trading partner. What investors want to know is, is the US an inevitable victim of the Chinese economy?

While we admit there is cause for concern, and no one has a perfect crystal ball, we don’t think it’s time for investors to push the panic button. Instead, it’s time to exercise caution, like trimming exposure to Chinese and emerging markets and the handful of US and multinational companies with the largest exposures to the Chinese economy. Here’s why.

China’s economy is still growing, and likely to continue. For many years, China’s GDP grew at double-digit rates, but as its economy ascended to the world’s second-largest, those rates became physically unsustainable. China now says it’s growing at “only” 6.5% a year, still stupendous, even if, as many believe, official reports are doctored and the rate is lower by a percentage point or two.

What’s happening, some observers say, is that China’s economy is changing, from one dominated by manufacturing to one where services account for a more sizable portion of national output. This natural cooling helps explain why prices for oil and other commodities, propped for so long by expansion of the Chinese manufacturing sector, have plummeted.

China’s stock markets are less indicative of recession than Western markets. Experts say Chinese equity investors typically speculate (think “gamble”) rather than invest, in contrast to American and European institutional investors, who dominate their stock markets. As a result, the Shanghai Composite exhibits exaggerated volatility. This was certainly the case in 2008 and 2009, when the index crashed by 72.0% in less than 12 months, which in the West is more than enough to presage negative economic growth. But what did it accompany in China? A five-point decline in real GDP growth, from plus 14.2% in 2007 to plus 9.2% in 2009.

The US is insulated from a good portion of the Chinese downdraft. The economies most exposed to China’s cooling are those whose GDP rely heavily on exports to China trade – like Taiwan (16% of its GDP), Malaysia (11%), South Korea (11%), Chile (8%), Thailand (7%) and Australia (8%). By contrast, exports to China account for only around 2% of US GDP.

The global risk is a possible ripple effect that slams economies most dependent on China and on the prices of commodities that spreads to sounder economies. Major oil exporters, like Saudi Arabia, Russia and Venezuela have already been hard-hit, and UK banks, with $198 billion in outstanding loans to China, could be in serious jeopardy if events in China snowball. As for how this relates to the US economy, any potential implications seem overdone at this point.

China leaders still have options at its disposal to improve conditions including interest rate cuts, infrastructure spending, lower taxes and reduced bank reserve ratios.

Meanwhile, the Chinese economy may, in fact, be experiencing nothing more than the effects of a transition to a more mature economy, and the Shanghai Composite will recover, as it did after 2009.

US large cap stocks appear to be fairly valued, and selective small caps may be buying opportunities. But as for China, the perspective from here is that there’s no reason for any rash moves, no abandoning the ship or making any major course corrections.