China: Separating the Signal from the Noise

ChinaTo say the least, global financial markets are off to a bad start in the New Year. Given all of the headlines surrounding China, we thought we would give a market recap and try to untangle recent events, sorting out the clamor from the meaningful developments.

What’s Up With China?

The facts are easy to see. The Shanghai composite is now down almost 16%, only a few trading days into the New Year. Even the large-cap CSI 300 index is down 15%, signaling big outflows from China’s equity markets.

Chinese regulators tried to arrest the fall by implementing ‘circuit breakers’, similar to what is built in to American markets, where trading is halted for a time if stocks fall more than a certain percentage, and then closed for the rest of the day if they fall even more after reopening. The idea is to make everyone take a break and cool off in times of extreme volatility.

Chinese markets have been blowing up these circuit breakers. On January 4, markets lost 7%, triggering the circuit breaker and closing the market for the day. Then on Thursday, January 7, Chinese markets opened sharply lower in the first few minutes. The 5% drop triggered a 15-minute halt, but when trading resumed, the slide resumed as well, again triggering the 7% loss and market close for the day. Thursday’s trading day lasted only 29 minutes. 

Some believe the circuit breakers were actually adding to the volatility, making investors nervous to sell everything before the market was shut down. Chinese authorities have now removed the circuit breaker rules. Whether or not this was the right decision remains to be seen, but what is clear is that the scrambling of policy makers and the constant changing of rules is only adding to the uncertainty.

Uncertainty Is The Market’s Worst Enemy

Chinese authorities have been pretty quiet as to what is going on behind the scenes. Bloomberg reports Chinese state funds have been buying up some of the largest company shares to try to prevent their stock markets from sliding further. This is exactly what they attempted to do this past summer when their markets crashed over 30%, something we covered here.  

We previously predicted the Chinese stock market bubble, noting that it was being driven by the Chinese government’s policies, rather than company fundamentals. After the initial bursting of the bubble, markets stabilized as unprecedented policies took hold. But those policy measures don’t solve the underlying problems, and we may be seeing the rest of the bubble deflating now.

What caused the Chinese stock market to decline these past few days? Nobody knows. Trying to speculate is like trying to point to the single snowflake that causes an avalanche. It is not the single snowflake; rather it is all of the snowflakes that built up previously. In the case of China, it is the massive amount of debt, government stimulus and policies aimed at getting retail investors to borrow money and put it into the stock market that caused a massive pile of snow to become destabilized.

The Chinese Yuan Will Be Paramount in 2016

Adding to the uncertainty is the change in the value of the Chinese currency, the yuan. This summer, we noted how China surprised the world by undertaking a 2% devaluation against the U.S. dollar, the largest move ever since the yuan was pegged to the dollar.

At the time, China called it a “one-off depreciation,” but then once again, they surprised the world with another 0.5% devaluation of the yuan, on January 6. Just the same as last time, the depreciation shouldn’t be a surprise to readers of this site who are well aware of currency wars and the policy of deliberately weakening your own domestic currency to try to spur exports and boost GDP.

This may be one of the reasons for the further devaluation of the yuan this time, as China’s economy is increasingly showing more signs of slowing. Another reason may be because the yuan is still fixed to the dollar, and China is burning through too much of its reserves to support the yuan as the dollar strengthens.

China now finds itself in a tough spot. If it devalues the yuan more to boost exports and help alleviate its debt burden, it will cause increased capital flight and further stock market declines. This in turn not only wipes out individual investors, but also puts big companies and state-owned enterprises in trouble. If it tries to prop up the yuan, it may not have the reserves to do so, and its debt burden becomes worse. This is the problem with market interventions. One intervention to alleviate one problem spurs other unintended consequences and problems.

What About the United States?

Similarly, the United States has an avalanche of problems waiting for the next snowflake to push it over the cliff. The U.S. markets are increasingly looking expensive, so a drop in Chinese stock markets was all that was needed to make investors in U.S. stocks reevaluate their risks and make them more nervous.

Add to this the global commodity glut and falling oil prices, along with a bond market that is getting weaker, and you have a very tenuous footing for the U.S. stock market going into 2016. Notably, gold has been holding up, reaffirming its position as a safe haven during times of distress. If a recession gets underway in 2016, we could see gold prices fall along with general deflation, but the long game is that central banks will likely step in again amidst cries to “Do something!”

Therefore, the best thing to do in 2016 is to continue to manage your personal budget and finances responsibly, save and invest as much as you can, and hold a small portion of your wealth in gold as insurance and as a hedge.

Chris Kuiper, CFA is currently a student and researcher at George Mason University, pursuing a Master’s of Economics. His previous experience includes asset management, investing and banking.