Just as they did when Chinese stocks swooned in July, global investors appear to be learning the right lessons about China for all the wrong reasons. Investors who can see through the haze and confusion can keep picking up bargains in undervalued markets like Indonesia.
First and foremost, the latest stock-market turmoil does not mean that China’s economy is in a meltdown. Yes, China’s economy is still slowing as investment retreats and exports decline. Spending by China’s emerging middle class remains a bright spot. But the service sector’s growth isn’t powerful enough to counteract the slowdown in China’s industrial sector. Most predictions are for growth of roughly 6.4% this year, slightly below the government’s 6.5% target.
What’s driving the selloff? Not global investors jittery about China’s growth prospects. China’s markets remain highly restricted to foreigners, who represent a tiny fraction of trading. On the contrary, trading in China is dominated by domestic, retail investors. This makes the market relatively volatile. Retail investors everywhere tend to trade more frequently are more prone to herd behavior. Many in China fled the market after last summer’s turmoil, which has left the market in the hands of an even smaller group of jittery, retail punters.
That’s why China’s new circuit breakers turned out to be such a bad idea. Intended to halt panics so cooler heads could prevail, the trading curbs proved too narrow for a market as volatile as China’s. In the U.S., a much less volatile market, trading pauses for 15 minutes if the S&P500 drops 7% or more and halts for the day only if the index falls 20%. China’s circuit breaker imposed a 15-minute halt after a 5% drop and halted trading if its CSI300 index fell 7%, a fluctuation all too common last year. So as stocks started falling, retail investors nervous they might be frozen into positions if the circuit breakers tripped joined the stampede to sell. The circuit breakers thus heightened volatility. Realizing this, regulators scotched the breakers Thursday night.
Most of these domestic, retail investors in the stock market aren’t middle-class consumers. They’re relatively affluent individuals who invest a conservative portion of their net worth in stocks. Volatility in China’s stock market therefore poses little threat to the overall wealth of China’s middle class and its ability to spend.
So what caused these wealthy punters to take flight? Because China’s economy is so tightly controlled by the government, and the stock market so dominated by big government-controlled companies, investors in Shanghai have long looked to signals on policy, rather than corporate profits, to drive markets. Beijing’s intervention in the stock market last summer has only reinforced this logic. So signals over the weekend that President Xi Jinping might favor painful economic reform over feel-good stimulus measures touched off this week’s selling.
Does that mean we shouldn’t be worried? Absolutely not. While China’s slowdown by itself isn’t enough to derail global growth, it won’t help. As times get tougher, growing labor unrest is a worrisome red flag. And the more growth slows, the more difficult it will be for China Inc. to service a mountain of corporate and local government debt that by some estimates has swelled to 250% of GDP. China is inching closer to a possible credit crisis.
That’s particularly true now that China has removed its gloves to join the global currency war already underway between Japan and Europe. It fired a shot across the bow in August with a one-time depreciation of its currency, the yuan. Then in December, the People’s Bank of China started marking the yuan down with the currencies of China’s major trading partners.
Some economists believe most of that revaluation lower is complete. Not likely. Central banks in Europe and Japan, which are using weaker currencies to try to revive growth, will now likely need to push their own currencies lower still, which will prompt China to nudge the yuan lower with them. That creates a vicious circle of depreciation.
Worse, China’s decision to move the yuan lower appears to be accelerating what was already a torrent of outflows by Chinese savers eager to get their cash out of the way of the slowing economy and a widening crackdown on corruption. China is trying to discourage the outflows by cracking down on foreign-exchange transactions and even trying to influence rates for yuan offshore. But the vacuum of funds out of banks is pushing up the cost of credit, forcing the PBoC to print yet more yuan to inject into the banking system – a measure that stands to weaken the yuan even further. And Jefferies warns that liquidity is likely to tighten even more ahead of the Lunar New Year holidays a month from now.
A weaker yuan will ultimately be good for China’s exporters and stocks. But because it inflates China’s economy by exporting deflation, the cheaper yuan is bad for economies that rely on exporting to China, like Australia, or that are using a weaker currency to try to inflate their own growth, like Japan.
Not surprisingly, stocks in Australia and Japan suffered the biggest declines in Asia outside China this week, falling 5.8% and 5.4%, respectively. Also hit hard was South Korea, which has one of the region’s highest exposures to China’s import demand. Stocks there have dropped 2.8%.
But the turmoil doesn’t alter the overall outlook for regional markets this column laid out earlier this week. Because it’s most likely to enjoy government support, China’s stock market is still likely to outperform its neighbors’. And stocks in a handful of Asian markets still stand to exceed investors’ rock-bottom expectations. This week’s declines have made stocks in Jakarta, for example, even more attractive.
Comments? E-mail us at wayne.arnold@barrons.com
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