August 2015 Market Commentary

In this section we usually discuss what happened in domestic stocks and bonds, in global stocks, and general outlook, though August was also (clearly) an ugly month with a LOT of noise at the end, so we’re making an exception this month and just discussing the past few weeks about China.

According to Ruchir Sharma, head of emerging markets for Morgan Stanley Investment Management, in July of 2015, “Every single major global recession in the last 50 years has started in the US. The next global recession will be made in China.” Talk about foresight AND timing.

Really, what happened in China was a global contagion. I’ve been saying to anyone who will listen for years that I don’t believe the numbers coming out of China; how can the country be so successful in spite of a Real Estate bust, a huge portion of the country living below the poverty line, a ‘forced’ stock market (the country has been propping it up with words to convince ordinary folks to invest), and most ridiculously – you probably won’t believe this – their unemployment rate has stayed between 4% and 4.3% since late 2002! However, it’s not just me who has had these thoughts, many others have as well (Neuberger Berman, Goldman Sachs, Lord Abbett, etc.). However, we’ll speak further on this at the end.

China accounted for almost 40% of global growth last year, its appetite for raw materials has undergirded economies from Australia to Brazil to South Africa and its production capabilities have lowered prices of industrial machines and consumer goods everywhere money changes hands. But it’s also kind of a mess. Fueled by real estate and shadow banking, China’s debt quadrupled from 2007 to 2014 according to a McKinsey analysis. Its economic growth is slowing, pollution is awful, and a hawkish foreign policy is alienating neighbors. However, investors were willing to ignore all that because of their faith in technocratic excellence of China’s economic managers, but that faith has been destroyed by this year’s bungling of the stock and foreign exchange markets.

We’ve been trying to highlight the importance of today’s world economy when compared to decades ago. In a genuinely globalized economy, which is close to what we live in, excesses and imbalances in one corner of the world inevitably affect other countries. In many ways, President Xi and Premier Li Keqiang were doing the right thing – trying to push the economy away from its addiction to exports, manufacturing, and construction and toward producing goods and services for consumers at home. They also vowed to give the free market a “decisive” role in setting prices and interest rates. But they couldn’t reconcile that with the Communist impulse to control the commanding heights of the economy and tamp down the natural volatility of capitalism. So what happened in August is precisely what markets do; underreact to new developments for a long time and then abruptly overreact.

All this sounds bad, but a good point was raised by Peter Coy in Businessweek, especially the end about the US:

“How much we should worry about China has lot to do with the definition of ‘we’. Most at risk are countries such as Turkey and South Africa that have heavy debt denominated in foreign currencies like the dollar, persistent inflation, and economies prone to trade deficits. When investors lose confidence in emerging markets, countries like these are always the first to suffer.

“Although less connected to China, Europe is at some risk, because its economy is barely growing, making it vulnerable to even a smallish shock. Asian nations such as South Korea and Singapore that sell a lot to China have obvious exposure, but they’ve amassed huge foreign reserves that protect them against speculation. With its huge domestic market, America is always more insulated than other nations from the ups and downs of global trade. Exports to China amount to only 1 percent of GDP. And crude oil at about $40 will lower the price of gasoline, giving US consumers more money to pay down debt and eventually increase spending on other things.”

In summary, we can look at the Chinese issue such that financial markets depend on good information. When it’s lacking, investors flail. They assume the best when they’re bullish and the worst when fear gets the best of them. That helps explain the eruption over China, a nation that remains opaque despite having the world’s second biggest economy.

Going back to what we discussed earlier about China, I’ve been asked recently “are you concerned, what are your thoughts for the end of the year, etc.” My thoughts are simple, I think the rest of the year will be fine; I don’t have any way to determine the future. However, I believe the coming earnings season in October/November will be key. This goes immediately back to China. If the CEOs and other senior executives at US firms were also in the position of not entirely believing Chinese economic figures then the guidance they gave previously would have included a lower estimate of assumptions and Q3 earning season will be generally unaffected by what happened in August. However, if the majority of executives believed that Chinese growth was as strong as China itself said, then we could be in a tremendous pickle as third quarter earnings could fall precipitously – and more importantly – forward guidance could be reduced. So, the determining factor to me on how this year will end and the “strength” of the US stock market is all going to come down to management’s discussion of their third quarter earnings figures, which is released in October/November.

To end, this is just a collection of a few data points. It doesn’t portend the end of the world. China still has a lot of strengths, including plenty more room to cut interest rates if needed and a war chest of about $3.6T in foreign exchange. However, what it lacks for the first time in a while are trusting investors.


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