With China’s two major stock market indices falling more than 30% over the past month, investors may question whether this signals an economic decline. In context, we do not see China’s swoon in stock prices as a harbinger of economic downturn. Rather, we believe the Chinese central government is currently engaged in several complex “balancing acts” with regard to its economy and financial markets.
Balancing Act #1:
Chinese government officials have stated that they would like to shift the economy away from dependence on export manufacturing and infrastructure investment and toward the domestic consumer. Traditionally, this means moving away from inefficient spending by state-owned enterprises and toward higher-return investments funded by private enterprise. However, the Chinese economy is slowing more quickly this year than the central government would like. In response, the government is balancing measures that encourage economic efficiency and sustainable growth with more traditional stimulus measures that increase growth but through potentially inefficient means.
Balancing Act #2:
Chinese government officials have also stated that they would like to gain international legitimacy for its currency and capital markets. They would like the renminbi to be included in the International Monetary Fund’s special drawing rights basket and for regional trade in Asia to be settled in renminbi, making it a regional reserve currency. In addition, they would like their equity markets to be included in the MSCI and other global indices in order to attract foreign investment flows. However, it appears as though the combination of steady economic stimulus and measures to open the currency and capital markets may have together inflated a bubble in Chinese equities, which has led to some countermeasures like restrictions on margin debt. Again, China is trying to strike a balance between a more open and attractive investment environment, yet one that is not so attractive as to inflate an unsustainable bubble.
While the approximately 32% decline in the Shanghai Composite since its peak on June 12, 2015 sounds scary, a number of considerations help put this in perspective:
- The Shanghai Composite was up 60% year to date before the decline, and 160% in the twelve months before the decline – so we see this as a correction of excesses.
- China is a developing economy with immature capital markets and has historically experienced similarly wild equity swings – so in our opinion this is not all that unusual.
- About 6% of Chinese citizens are invested in the stock market, compared to about 49% of Americans – so we anticipate the impacts of this decline are likely to be contained.
- Because the Chinese equity market is not a classic open and free market, historically its performance has had very little correlation with the underlying health of the Chinese economy, and more to do with technical flow of funds considerations like the recent connection of the Hong Kong and Shanghai markets. So we believe the recent decline in Chinese equities should not be read as a barometer of impending deterioration in the Chinese economy, just as the 160% run up to the peak was not an indicator of an improving Chinese economy.
Overall, we believe the Chinese government has been much more skilled at balancing short-term and long-term considerations in its economy than in its equity markets, where the faster pace of events appears to have caught it off guard and led to a rapid series of policy changes that could ultimately be counterproductive. Fortunately, it is economic growth in China that is much more important in terms of the impact on price performance across asset classes; the spillover effects of China’s equity market performance are likely to be much more limited. In line with our risk management discipline, we are monitoring the effects of economic growth in China as well as the Chinese equity market selloff, but at this point we have not taken any portfolio-specific actions.
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