China and the U.S. Stock Market

Posted by Brad McMillan, CFA, CAIA, MAI

Find me on:

This entry was posted on Aug 28, 2015 2:00:00 PM

and tagged In the News

Leave a comment

U.S. stock marketNow that things seem to have calmed down a bit, it’s a good time to discuss why the past week has been so turbulent. The usual explanations—the Chinese currency devaluation and stock market crash—are certainly valid, but there’s more to the story.

Let's take a closer look at the connection between the news from China and U.S. stock prices.

China’s economy appears maxed out

The Chinese economy drives both the country’s currency and its stock market. Despite the government's efforts to shift to consumer-driven growth, the economy remains dominated by manufacturing for export and infrastructure spending. Both have essentially maxed out, with little or no room for further growth.

Exports have been declining, due in large part to an appreciation of the Chinese currency. Other countries, with cheaper currencies, are now less expensive to manufacture in, and China is losing business.

Note that the U.S. isn’t one of those countries. Although it would like to, China does not yet compete directly with the U.S.; its main rivals are still other nations at the lower end of the value chain. The yuan devaluation was aimed at these countries, and it has succeeded in forcing many of them to devalue their own currencies.

The problem is that companies in these countries have reportedly borrowed about $9 trillion in U.S. dollars. As their currencies depreciate, those borrowed dollars get harder to pay back, which may very well lead, over the medium term, to defaults and more problems. 

What does this mean for U.S. markets?

For institutional investors, China’s current situation brings back old memories—specifically, the Asian financial crisis of 1997–1998. Similar currency problems led to mass defaults that shook the U.S. financial system. There are significant differences between now and then, but markets often react first and think later. In fact, that’s exactly what we saw this week, with markets running scared and then moving back up. 

The other issue for U.S. markets is what the overall slowdown in Chinese growth will mean for the world. The assumption was that the Chinese government was in control and that it would be able to keep growth at expected levels. Its botched response to the initial decline of China’s stock market called that assumption into question, and the shock announcement of the currency devaluation looked to many like a desperate move to increase exports again.

I don’t think that was the case. As noted above, China’s currency had actually appreciated recently, and the devaluation simply brought it back down a bit. Here in the U.S., though, it didn’t really matter because we don’t compete that much with China.

What did matter was the perception that Chinese growth was so much worse than expected that the government might be panicking. Again, I don’t think that's the case, but markets shot first and asked questions later.

Uncertainty may not be fully priced in

At the end of the day, uncertainty has risen dramatically—not only about the second-largest economy in the world but about the entire emerging market space. Markets hate uncertainty, and recent price volatility reflects that.

The question going forward is whether heightened uncertainty is fully incorporated in current equity prices. With U.S. prices down about 6 percent, it may be . . . but then again, it may not. An adjustment of this moderate size suggests that investors now expect China to stabilize and grow at rates close to recent history, and the emerging markets to more or less do the same.

U.S. growth should continue to hold steady, but these underlying assumptions worry me. I suggest you draw your own conclusions and act accordingly.

                      Subscribe to the Independent Market Observer            

Subscribe via E-mail

New call-to-action
Crash-Test Investing
Commonwealth Independent Advisor

Hot Topics

Have a Question?

New Call-to-action

Conversations

Archives

see all

Subscribe

Disclosure

The information on this website is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Please contact your financial professional for more information specific to your situation.

Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets.

The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. All indices are unmanaged and investors cannot invest directly into an index.

The MSCI EAFE Index (Europe, Australasia, Far East) is a free float‐adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of 21 developed market country indices.  

Third party links are provided to you as a courtesy. We make no representation as to the completeness or accuracy of information provided at these websites. Information on such sites, including third party links contained within, should not be construed as an endorsement or adoption by Commonwealth of any kind. You should consult with a financial advisor regarding your specific situation.

Member FINRASIPC

Please review our Terms of Use

Commonwealth Financial Network®