Expect more ups and downs on global stock markets

30 Aug 2015 | Author: | No comments yet »

As the Stock Market Swings.

By the close of the stock market on Friday, the recent ups and downs in share prices had worked out to a mild correction. The collapse in Chinese markets has brought into focus a question that Western nations have been grappling with since the 2008 financial crisis: how much, if anything, stock markets have to do with the real economy.

After a dizzying two weeks that saw a rapid plunge and rebound in equity prices, investors are looking forward to a week of economic data that may provide clarity on the likelihood of a near-term US interest rate hike and help tamp down the market’s recent wild swings.Anyone trying to design an event to bring Xi Jinping’s China back to Earth couldn’t have engineered something much more elegant than the turmoil in China’s financial markets and the resulting global aftershocks. Warning signs that Chinese stocks were overheating have been clear for months, and the scenes of distraught retail investors losing their life savings as prices began to snap back in June barely made a ripple in global markets, until last week.

Yet the jolt may have been just large enough to change the country’s underlying bargain between ruler and ruled—and by doing so, to temper Beijing’s current tendency toward arrogance, rigidity, belligerence and diplomatic hectoring. The Shanghai and Shenzhen brokerages were viewed as one step above casinos, with 80pc of the daily trading volumes coming from ordinary retail investors allowed to leverage up to the hilt on a state-sponsored bull run. Car sales, construction spending, the Federal Reserve’s “beige book” and jobs growth may show the economy is strong enough to withstand the first rate hike in nearly a decade from the Federal Reserve, despite worries about a hard landing for China’s economy. If the week’s tumult has reminded Americans nervously eyeing their retirement funds of the interconnectedness of the global economy, it may also serve to remind today’s proud Chinese leaders that they too exist in a larger context—that they need their neighbours, that they need the US and that they might need to become a little more accommodating.

Peter Fitzgerald, Aviva Investors’ head of multi-assets investments, said: “There’s a big difference between the Chinese economy and the Chinese stock market. These dramatic falls, which followed a more gradual but still stomach-churning 11.5pc decline in Chinese stocks the week before, ripped through global markets. Global stock markets were stung by severe swings in recent weeks, stoked by concerns that a slowdown in China’s economy may be more harsh than anticipated. As President, Mr Xi has seemed pleased by his ability to seize and use power—to have China’s weaker neighbours genuflect and have the world respond more compliantly.

America’s Dow Jones Industrial Average share index plummeted an unprecedented 1,000 points, before closing 588 down – its biggest decline for four years. But after confirming a move into correction territory, the S&P 500 rebounded to score its best two-day percentage gain in over six years this week, as comments from Fed officials led some investors to believe the market turmoil and global growth concerns had diminished the possibility of a rate hike at the central bank’s September meeting. In the last 25 years, the Shanghai Composite, China’s benchmark stock index, has closed within one percentage point of the previous day’s close on just 56% of all trading days, with an average movement of 0.09% (see chart). A society that had grown accustomed to dismissing anyone it didn’t like—including the US—has been rattled by a marketplace that doesn’t know what obedience is. A prolonged slowdown is more likely to provoke social unrest in China than in other developed economies, because stability there has been based on high growth rather than political and other institutional arrangements.

Some City insiders have pointed to Beijing’s decision to devalue the yuan on August 11 as a warning that China’s economy was indeed slowing; others suggested disappointing data on manufacturing growth a week later was the trigger. Fed Vice President Stanley Fischer told CNBC during the Fed’s annual conference in Jackson Hole, Wyoming, that the committee was “heading in the direction” of higher rates. Much of China’s growth in recent decades has depended on the cultivation of capitalism, but having implanted the quintessentially capitalist institution of stock markets in its midst, the Chinese Communist Party’s leaders have now been forced to confront a creature of their own making as it rises up and goes its own way, immune to their attempts to bend it to their will. Others still have said it was the People’s Bank of China’s failure to intervene to prop up the market over the weekend of August 22-23, as it had done during previous wobbles, that finally unnerved traders. Traders in futures markets that bet on rate increases boosted September’s odds after his words. “There is a narrative out there that Yellen’s Fed is looking for a reason to delay the rate hike; I don’t think that is necessarily the case,” said Brad McMillan, chief investment officer for Commonwealth Financial in Waltham, Massachusetts.

Such market gyrations have, more than at any time since the Lehman Brothers collapse in September 2008, raised fears of a renewed financial crisis, with all the related economic, political – and human – fall-out. After a stronger-than-expected revision to second quarter gross domestic product and solid durable goods figures, another run of strong data next week could bolster the case for a rate increase next month.

The free fall in the stock markets has been especially unnerving in a society over which the party has long pretended to ride herd—and has heretofore done well enough at creating economic growth that it had come to seem invincible and omnipotent. The Fed has generally played down the potential impact of China and other international headwinds, while asserting that the negative effects of low oil prices and a strong dollar were likely to be temporary. The PBOC was throwing “everything but the kitchen sink” at the crisis, with interventions in both equities and currencies, according to Andrew Polk, senior economist at The Conference Board, as the central bank seemingly tried to get out in front of the expectations of increasingly frazzled markets. But traders also are also mindful of the fact that the Chinese slowdown could hit US companies and their shares disproportionately in the second half of the year, with luxury goods companies and industrials among the groups paying a price. Judging by the market’s historic volatility, the 8.5% sell-off on Monday was indeed an extreme anomaly, with the daily return falling more than three standard deviations away from the average—a so-called “three sigma” event.

Thomson Reuters data shows third-quarter earnings expectations have dropped 6.4 percent for the industrial sector and 8.8 percent for the materials sector since July 1. The New York Stock Exchange used its circuit breakers, installed after the 1989 crash, to pause stocks on 1,278 occasions on what was immediately dubbed Black Monday.

While cutting interest rates for the fifth time in nine months, Beijing also tightened rules on short-selling, banned large shareholders from offloading stakes and forced local pension funds into domestic stocks. Should analysts continue to downgrade their expectations for third- and fourth-quarter earnings in those sectors or more broadly, that could make stocks more expensive, even after the recent selloff. “It is more important to the US whether or not GM and Ford can sell cars there,” said Kim Forrest, senior equity research analyst, Fort Pitt Capital Group in Pittsburgh.

Enjoying torrid two-figure growth rates, China boasted urban skylines bristling with cranes and towering high-rise buildings while its countryside became laced with freeways, high-speed rail systems and wireless telecom networks. Indeed, the FTSE 100’s 4.7% drop on Monday, at 4.2 standard deviations from its average return, was a bigger outlier (about 1 in 10,000) than China’s market decline, at 3.2 standard deviations (5 in 10,000). A year and a half ago, the composite index of China’s once-placid stock markets—one in Shanghai where 831 companies are listed and one in Shenzhen listing some 1700—started its rapid and stratospheric climb, as if it had suddenly grown embarrassed by its relative languor. But this year, the big increases in sales and prices have come at the high end of the market, where investment wealth is assumed to be more of a factor in the decision to buy than wages and salary.

The reversal on Western markets, meanwhile, was largely driven by a senior Federal Reserve official hinting that an interest rate rise, previously signalled for September, is now “less compelling” given renewed financial volatility. By June, the Shenzhen market had risen by some 135 per cent and Shanghai by about 150 per cent, with a combined market capitalisation of more than $US9.5 trillion ($13,200 billion). A similar sentiment has spread to the UK, with investors betting the Bank of England won’t raise rates until October 2016 – six months later than expected just a few weeks ago. There is also now rampant speculation, which the Fed isn’t discouraging, that America will soon engage in yet another round of quantitative easing – so-called QE4. The party’s own mouthpiece, the People’s Daily, exhorted “the broad masses” to join the feeding frenzy, claiming that China’s bull market was just beginning.

While there’s a history of authorities intervening in the markets, it’s tended to happen when values are very low and it was needed to support confidence. The Western world is similarly engaging in gross market distortion, albeit of a different kind – by keeping real interest rates firmly in negative territory and, once again, desperately stoking shares with the promise of further hundreds of billions of dollars of virtually printed money.

When China’s stock markets finally started their hyperactive rise, one more cog in this well-oiled juggernaut of progress just seemed to be kicking into gear. Call it “the China dream” (as Mr Xi does) or “socialism with Chinese characteristics” (as the party likes), but many Chinese were only too glad to proudly embrace this new vision of rejuvenation and prowess.

American central bankers have been signalling for two years that the crisis-era programme of vacuuming up bonds from the market, known as quantitative easing, would be wound up as the economy improved. Having grown 9.8pc a year since the late-1970s, the economy of the People’s Republic now outstrips that of America on a purchasing power parity basis (adjusted for living standards). It was enough to make any foreigner envious, especially when so many Western economies lay like St Catherine, bound to a wheel of endlessly depressing cycles of capitalist boom and bust.

Even this approach wasn’t enough to prevent the “taper tantrum” of 2013, when the markets took umbrage at the suggestion that the Fed would begin to tighten monetary policy. In recent months, growth has slowed – with official forecasts pointing to a 6pc to 7pc expansion in 2015 and some analysts questioning the veracity of government statistics.

Meanwhile, here was China, a country that president Bill Clinton once consigned to “the wrong side of history”, making a glorious end run around the verities of all the vaunted Western development theorists. China’s abrupt interventions have therefore come as a surprise to investors who have only recently gained direct access to the country’s A-share market. After years of experimenting with what Deng once called “crossing the river by feeling the way over the stones”, China had seemingly arrived safely on the other side—and built not just a Chinese model but an economic perpetual-motion machine that had the added virtue of being patented in China rather than abroad. “The Chinese model has transcended the dichotomy between socialism and capitalism,” proclaimed Li Xiguang, a professor of media at Beijing’s Tsinghua University. “It has broken down the universe of discourse of the old market style of economy and proven that there is no singe narrative that is suitable for the whole world.” Mr Xi himself has sounded similar notes. “One part of the now long-standing Chinese leadership critique of Western-style democracy is that it is prone to paralysis and gridlock and ultimately governmental weakness,” he said in September last year in Beijing’s Great Hall of the People. When he met President Barack Obama in June 2013 at the Sunnylands Retreat in Palm Springs, California, Mr Xi proposed a “new model of big-power relations,” suggesting that Chinese success had bought it a seat at any geopolitical table. This confidence in the strength of the China model—and the supposed weakness of its Western competitors—has reshaped the way Beijing relates to the world.

The more optimistic watchers point out that the US markets have just been through the third-longest period in the past 90 years without a major market fall of at least 10pc. Having said that, China’s property market, which drives economic sentiment to a greater extent than equities and underpins the banking sector, remains buoyant. Its new confidence in its wealth and power has been matched by an increasingly unyielding and aggressive posture abroad that has been on most vivid display in its maritime disputes in the South and East China seas. China has claimed a protrusion hanging down from Hainan Island into the South China Sea like a giant cow’s udder, along the Vietnamese and Philippine coastlines all the way to Indonesia.

Some also sound a note of caution about the timing of the rout, during what is normally the height of the summer slowdown on trading floors around the world. The audacity of insisting that all the contested atolls and islands in the region are sovereign Chinese territory—and the uncompromising attitude with which Chinese officials pressed the claim—marked a more aggressive phase in Chinese foreign policy. The lack of trades magnifies the effect of the deals that take place, particularly if the only players left making bids and offers are computer programmes designed to seek out and exploit any liquidity. A few analysts—mostly notably David Shambaugh, a George Washington University professor, in these pages in March—have warned that the centre of this new Chinese proposition cannot hold.

Despite its apparent economic success, Professor Shambaugh argued, China was plagued by unresolved contradictions and headed for “a breaking point”. However, UBS also has deeper concerns about China’s health. “We take the sell-off very seriously, as this unfamiliar mix of emerging market uncertainty, deflationary pressure, central bank interference, and extreme volatility is hard for global markets to digest,” he said. UBS has crunched the numbers on a possible Chinese slowdown and has estimated that a 1pc drop in economic growth would knock up to 0.4pc from Europe’s output.

If only those pesky emerging markets could run themselves properly, goes the Western narrative, then we would not have to endure the market volatility caused by their bad decisions. Even though China buys relatively little from European trading partners, equating to about 3.1pc of overall exports, a slowing consumption of fuel, commodities and consumer goods might spiral into deflation further afield. On Tuesday the European Central Bank’s vice-president, Vitor Constancio, tried to dampen anxiety over an economic slowdown in China, saying that the economy did not show signs of major deceleration and that Europe’s central bank stood ready to intervene if deflation reared its head. In 1998, an emerging markets crisis, starting in Thailand and then spreading across Asia to Russia, was indeed the catalyst for a significant downturn on global markets. The collapse derived from chronic private and public sector indebtedness across such countries, many of which were in the throes of emerging from years of economic isolation.

But without the central banking might of Beijing, or its $3.65 trillion capital reserves, they are consigned to wait for signs of progress from within China. The annual Jackson Hole get-together this weekend has allowed the US authorities to drop more hints about what the China shudders might mean, with every morsel on inflation and interest rates carefully watched. The Communist government’s next five-year plan will be aired in October, with Premier Wen Jiabao’s desire to move more people into urban centres likely to continue unabated. The plunge was all the more unnerving because it belied the party leadership’s conceit that their superior formula of governance could safely guide the economy through just such cyclical shocks. If we are on the brink of another “Lehman moment”, then it is the West’s response to the sub-prime crisis – above all, our continued reliance on growing debt and monetary stimulus – that must take a large share of the blame.

This pretension had not only helped create a mythology of can-do omnipotence and invincibility around party leaders but also helped silence foreign critics of the slow pace of economic reform and the complete absence of political reform. Then there is the dark shadow that has long been cast over global markets by the potential unravelling of the grossly incoherent grand project that is Europe’s single currency. In part, to demonstrate to the International Monetary Fund enough flexibility that Washington might deign to allow the yuan to be included in the official reserve currency basket.

And on August 12, a chemical warehouse serving the port city of Tianjin blew up in a devastating explosion that incinerated whole lots full of export vehicles, demolished thousands of apartments, killed some 140 people and spewed untold quantities of toxic chemicals into densely populated neighbourhoods. For China’s leaders, the most profound problem with this string of events isn’t simply the monetary loss or the body count but the overall psychological effect. But some of our managers were buying in because they were seeing the indiscriminate market falls lowering the price of what they see as quality companies.” At Aviva, Mr Fitzgerald said: “I think if you’re an investor who is taking a medium-term view, three years rather than three days, it was a good opportunity to put some capital to work.” China’s central bank catches the world markets off-guard by cutting its benchmark lending rate, stoking concerns that the world’s second biggest economy is in need of stimulus to continue meeting the government’s 7pc growth target A survey of Chinese manufacturers shows that the sector has fallen into contraction.

Moreover, because the party leadership and central government purport to control so many aspects of Chinese life—from economics and financial markets to culture and politics—they get blamed first whenever anything goes awry. The PMI reading fell to 49.6, below the 50 mark that separates growth from decline, as market-watchers fret that property and industrial output have hit a wall. In the China equation, a crack in the edifice of trust can corrode confidence in party rule and threaten the legitimacy of the state—one of the leadership’s biggest fears. This grand bargain’s latest leader is Mr Xi, who has acquired far more power than any other recent leader—and, in the process, gained a reputation as an implacable, no-nonsense, if enigmatic ruler. Sometimes a crisis that shocks, even humbles, but doesn’t completely upend can catalyse a crucial moment of reflection that leads to reappraisal and even change.

The most encouraging news out of this week would be for Mr Xi and his comrades to recognise that China can no longer be such an island—that China cannot succeed in isolation, much less by antagonising most of its neighbours and the US. As large, dynamic and successful as China has become, it still exists in a global context—and remains vulnerable to myriad forces beyond the party’s control. If the alarms over the past few months presage such a revelation in Beijing, it would not only enhance China’s stability but its soft power and historic quest for global respect. But it also offers both countries a chance to work together on one of the greatest challenges of the century: forming a more effective partnership to tackle global climate change.

But if China should take any larger message away from its near-death tangle with its own financial markets, it is that neither country—nor the world at large—has much hope of dealing with the century’s shared problems if Washington and Beijing cannot find more common cause. Orville Schell is Arthur Ross Director of the Centre on US-China Relations at the Asia Society and co-author, with John Delury, of Wealth and Power: China’s Long March to the 21st Century.

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