Why China's Bear Doesn't Mean Broader Trouble Looms

Are Chinese markets the first domino to fall in what will become a global bear market? That question seems to be on many pundits’ minds lately, with tariff fears swirling, the yuan tumbling and mainland Chinese markets dropping -24.4% since January 26.^[i] Many suspect China’s “bear market” is an advance warning of huge problems for the world’s second-largest economy—with major implications for the global economy. However, we believe history and current economic fundamentals suggest otherwise.

First, consider: Is China’s market downturn really a bear market, or is it part of the ongoing global stock market correction that began in late January? At the risk of seeming pedantic, during corrections, not every country or index falls the same amount. While a correction is technically a sharp, sentiment-driven drop of about -10% to -20%, that general parameter refers to a broad index like the MSCI World, MSCI All-Country World (ACWI) or S&P 500 (for those more US-focused). In a global correction, it isn’t unusual for individual countries to fall more than -20%. In the correction from May 21, 2015 to February 11, 2016, the MSCI World Index fell -17.9%.^[ii] Yet 14 of 23 constituent country indexes fell more than -20%.^[iii] In 2012’s April 2 – June 4 correction, the MSCI World dipped -12.5%.^[iv] However, 7 of 23 nations breached -20%, led by Finland’s -26.4% swoon.^[v] Often, this is due to country-specific quirks. Many national indexes aren’t diversified. In China’s case, the Shanghai Index (the media’s main reference point) represents A-shares, which are traded on mainland exchanges and therefore largely inaccessible to foreign investors. As a result, mainland Chinese markets tend to be less efficient and often suffer big swings tied to speculation, as many domestic investors prefer property as a long-term investment vehicle. Sentiment, therefore, can have an outsized impact, making the Shanghai Index’s swings much more akin to corrections than bears. This is why whether an individual country’s index breaches a -20% decline—a somewhat arbitrary bear market qualifier—is much less significant than whether a major, multi-trillion dollar economic negative few see accompanies it.

No matter what you call the downturn in Chinese stocks, we believe it is unlikely to prove a prelude to deeper problems in the rest of the world. Consider recent history. From the global bull market’s birth on March 9, 2009 through this year’s start, there have been four Shanghai Index “bear markets.” Not even five months after this bull began, Chinese stocks fell -23.2% August 4 — 31, 2009.^[vi] The MSCI World Index didn’t even suffer a correction. Yet another Chinese “bear” started on November 23—less than three months later!—and ran through July 1, 2010. Global markets experienced a correction in early 2010, but not a bear. In November 2010, yet another Chinese “bear” started, with the Shanghai Index falling -33.5% through December 2012.^[vii] While broader markets endured three corrections over that span, the MSCI World rose 4%.^[viii] Similarly, the Shanghai Index fell -51.5% from June 12, 2015 – January 28, 2016—a period largely coinciding with the aforementioned world stock market correction.^[ix] But there was no global bear.    

Moreover, China’s current “bear” doesn’t necessarily indicate looming weakness in its economy. Investors rightly see cyclical changes in broad-based, developed stock markets as potential leading indicators of economic conditions. Stocks generally look forward, anticipating likely economic conditions over the next 3 – 30 months (focusing most on the next 12 – 18). It seems to us folks apply the same logic to China, particularly given fears over tariffs. But mainland Chinese stocks don’t have a strong relationship with China’s economy. Despite the aforementioned four Chinese bears since 2009, the economy grew swiftly throughout that span. The 2009 and 2010 Chinese bears came while its GDP was growing at double-digit rates! Fast! Meanwhile, the Shanghai Composite’s early-2015 boom coincided with an economic slowdown.

While China’s growth has slowed in recent years, this is largely by government design and partly a natural consequence of compounding—even as the economy grows more in yuan or dollar terms, since the base is larger, it translates to a slower growth rate in percentage terms. Math aside, economic conditions in China appear healthy. China’s Official Manufacturing and Non-manufacturing Purchasing Managers’ Indexes (PMI) for June remained expansionary at 51.5 and 55.0, respectively.^[x] (Readings above 50 indicate expansion.) The Manufacturing PMI’s new orders subindex hit 53.2 in June—only a whisker below May’s 53.8.^[xi] Trade continues to expand, and retail sales continue to grow at double-digit rates. Lending grew a healthy 12.7% y/y in May.^[xii]

Now, those data don’t reflect the full scope of the forthcoming US tariffs—just steel and aluminum. But as Research Analyst Luke Puetz detailed here, the US tariffs (including threats) lack the scale to derail China’s economy. Payments should amount to a tiny fraction of GDP—at worst—and potentially less if China skirts new levies by shipping through a third party. Moreover, China’s central bank recently relaxed reserve requirements. That may in part be due to fear of slowing credit growth too much in its efforts to rein in the shadow banking industry, but it could also be an effort to offset even the very small effect of US tariffs.   

We aren’t arguing you should go hog-wild for mainland Chinese stocks, but we don’t think their “bear market” is a global risk. Overall, this looks like correction sentiment overstating the impact of tariffs on China’s economy.