The Global Equity Meltdown?

What is the number one trick in the quiver of the magician? The diversion.

Starting more than a year ago the Chinese stock market took off like a rocket, fueled, in part, by the very positive narrative coming out of Beijing. Stocks traded as high as 100 times earnings, a multiple not even Aesop could have fathomed in one of his tales.

It was a good narrative. The American economy was strengthening. The Fed was sure to raise interest rates. On the surface all was rosy on both sides of the Pacific. While China was slowing, it had to. It had to pivot from speed to quality or it would suffocate on the pollution it was creating and corruption would never be stopped, truly jeopardizing the legitimacy of the Communist Party of China.

In June the Chinese stock market, however, started to tumble, wiping out $3 trillion of market equity in two months, a loss 10 times larger than the entire GDP of Greece.

The government stepped in and out with measures to stem the fall. Large shareholders were prevented from selling, margin borrowing was brought under control, and state pension funds were allowed (perhaps even encouraged) to buy stocks; all, on the surface, in a bid to reassure investors and stabilize the volatile equity markets.

But, then, on August 24, the Shanghai Composite Index fell 8.5%, and, most shockingly, the Chinese government did nothing until easing monetary policy after the Dow Jones Industrial Average suffered its biggest three-day loss in history.

In the meantime, China devalued the yuan which postponed its desired inclusion of the yuan in the IMF’s basket of currencies. While many Westerners complained that China was artificially boosting exports after a dismal July export reading, China was, in fact, doing exactly what the rest of the world, including the US, have been asking it to do – to allow the yuan to trade more freely which is essentially the mechanism the government used to bring about the devaluation.

Most Western journalists are making the global equity meltdown a Chinese story. In fact, I believe, the impact will be far greater in the US and has been largely caused by the Fed’s QE policy – essentially free money.

Here’s why:

• China’s is a walled economy. While it plays on a global scale, the flow of currency, and thus wealth, is tightly controlled. Whatever condition the Chinese economy is really in, it is largely a self-contained ecosystem. And that’s the thing about economic activity – when it’s self-contained it’s all relative in terms of how people actually live.

• After the 8.5% drop in the Shanghai Composite Index (SCI) and the loss of $3 trillion of market cap in June and July, the SCI remained 46% higher for the year. The S&P is down 5% for the year, while the DOW is down 7%.

• In China, the stock market is dwarfed by the size of the US stock market. For China the total market cap of the equity markets is roughly 50% of GDP. In the US the markets have a value equal to 115% of GDP.

• In 2013, the US, for the first time, produced more oil than it imported. China produces roughly half of the amount produced by the US, so with oil now below $40 per barrel, US oil producers will be hurt while China’s exporters who use oil will see the double benefit of the currency devaluation and cheaper oil.

The misleading narrative about the Chinese stock market is that it is driven by retail investors, many of whom have purchased equities on margin and whose default could destabilize the country’s banking system.

In fact, only 10% of China’s healthhold wealth is held in equities. In the US 54% of Americans hold equities either directly or through IRA’s or 401k’s.

And as for all of the talk of the 5 fold rise in margin lending and what that might mean for the stability of the Chinese banking system I assure you it means nothing. The huge state-owned banks that control the banking sector would never even consider making a margin loan to a retail investor that wasn’t collateralized by more than the stock. They won’t even make business loans to successful mid-size businesses. The customer base of the China state-owned banks are the huge state-owned enterprises that are essentially collateralized by the government itself.

So what happens now?

The government set a GDP growth target of 7% for the first half of 2015 and according to official statistics they achieved it. But anyone who does business here knows that they have little chance of achieving that kind of growth in the second half and people may start to get a little anxious.

But now China’s largest single trading partner, who makes no attempt to control capital flows, may be about to catch pneumonia. How could anyone blame the Chinese government if it is unable to deliver on its growth target for the second half?

But what about the US? The Fed’s accommodative QE policy has wiped billions of dollars of debt off the books of corporate America, driving up stock prices and allowing many to make investments that might not have been justified with historically normal interest rates in place.

The reality is that few companies have fundamentally improved their productivity or fundamentally altered their business model. There are exceptions, and the US has been adding jobs. But it’s all relative.

As my father used to say, “There is no free lunch.”

As always in these situations, the world wants to find someone to blame. But it’s not China. China has behaved rationally, consistently, and exactly in the manner the West has demanded for the last five years or more.

Many Western companies will flee from China. Many already have. That is the worst possible decision they could make right now. In very short order economists around the world will be singing the praises of the Chinese government and lamenting the short-sighted objectives and results of QE2/3/4.

As a good friend often notes, suffering is part of life. The Chinese know this. The richest Americans don’t.

Don’t get me wrong. I am an American – a very proud American. Both of my parents fought in WWII – one in the Navy and one as a Navy nurse. Can you imagine a more horrible job to go to work to every day. Now passed away, however, she is the kindest and most gentle woman I have ever met.

A lot of the Western press has focused in recent articles about what this all means for the legitimacy of the CPC and the administration of Xi Jinping.

As I have said many times before, I believe he has the potential to be one of the great leaders of our time. Not because I like his hair, his famous wife, or even his politics.

But I do believe he cares about people and he is infinitely smarter than his critics give him credit for.

In the election of 2016 may the Americans elect someone equally worthy, lest their unwillingness to think inductively will put them at a continual disadvantage in the world financial markets.

A hand-written menu.  Sometimes it's better not to know anyway.  'Stuff' is sufficient.
There is no free lunch as my father used to say. Economists and financial advisors would have us believe otherwise. The long term question is which country is willing to accept that reality?

View the author’s literary work written under the pen name of Avam Hale. Both books are available at Amazon and most major online retailers in both electronic and print formats.

Copyright © 2015 Glassmaker in China

Notice:  The views expressed in this post are strictly those of the writer acting in a personal capacity.  They are not in any way endorsed or sanctioned by his employer or any other individual with which he may be personally or professionally affiliated.