China's Bubble Trouble

Posted by Brad McMillan, CFA, CAIA, MAI

This entry was posted on Aug 18, 2015 2:59:00 PM

and tagged In the News

Leave a comment

China5The news today is that the Shanghai Stock Exchange closed down another 6.5 percent, despite substantial support from the Chinese government. Given the market’s earlier declines and China’s surprise currency devaluation, the latest plunge suggests more trouble ahead.

What’s going on? There are four questions we need to ask:

  1. Is the Chinese stock market in a bubble?
  2. Is that bubble now correcting?
  3. What would that mean for the Chinese and world economies?
  4. And what would it mean for the U.S.?
This definitely looks like a bubble . . .

I define a bubble as the point at which asset prices become dependent on, and therefore coincident with, debt. There’s often an almost direct correlation between additional debt and an increase in prices. We’ve seen this repeatedly in the U.S., and the Chinese stock markets fit the pattern.

Based purely on debt accumulation, it sure looks like a bubble to me. The fundamentals also support this interpretation. Slowing economic and earnings growth, along with high valuations, are typically found at the tops of bubbles, as we see now in China.

And it does appear to be correcting

Although the Chinese government was able to stop the initial market declines, subsequent drops indicate that there is very little fundamental, nongovernment support for prices at their current elevated levels. Absent the confidence that pushed prices higher, there is no reason for them to rise again—and lots of reasons for them to decline further.

Repercussions around the world

This is a problem for both China and the world. Stock markets and economies are very different things and often only weakly linked; after all, the Chinese economy continued to slow even as the market took off. But this correction looks more like a symptom of problems in the larger economy than a cause of them, at least so far.

If so, slower growth in China could mean slower growth around the world. In this recovery, for the first time, the U.S. was not the main engine of growth; China was. When the locomotive slows down, so does everyone else. If the collapse in the Chinese stock market indicates slower growth there, and it may, the world will have to pay attention.

Most of the damage is likely to be in other emerging markets. Slower Chinese growth will mean lower demand for materials, damaging economies that depend on raw material production. A cheaper Chinese currency will put pressure on countries that compete with China for jobs. Slower global growth will hit every economy that depends substantially on global demand (i.e., most exporters).

The U.S., however, could benefit

By and large, the U.S. is relatively much less exposed to the rest of the world than other major economies. Our economy simply doesn’t depend as much on selling to others. This is bad when U.S. demand is poor. Right now, though, the U.S. is growing relatively quickly, and we benefit from that home-field exposure. Our companies do, however, buy raw materials, and those price declines are likely to boost the U.S. advantage even more.

Of course, there will be some damage here. The strong dollar has hit corporate profits, for example. But even with the dollar at 10-year highs, profits outside the energy sector are still growing and will probably climb faster as companies adapt to the new higher valuation.

If China is in a bubble that’s now correcting, which looks quite probable to me, it makes sense to worry about what might happen. Right now, however, the U.S. remains the fastest growing, most economically solid, and least exposed country to any potential problems. In fact, we might stand to benefit from a slowdown elsewhere in the world.

                      Subscribe to the Independent Market Observer            

Upcoming Appearances

Tune into CNBC's Squawk Box on Wednesday, August 29th to hear Brad talk markets.

 

5 Ways to Affiliate
Commonwealth Independent Advisor

Hot Topics

Have a Question?

New Call-to-action

Conversations

Subscribe via E-mail

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®