The Great Stall of China

People who know I used to be an investment advisor do not ask me whether they should buy or sell. Most people want to know why the market is doing what it is doing. And they are right to ask that; if the cause is seen as temporary, they would probably hold. If the cause appears to be more fundamental or “secular,” they consider reducing exposure to falling stocks.

Okay, so why is the market falling?

The single biggest reason stocks are falling right now, is because China’s economy is stalling out. Some context first:

China has been the fastest growing major economy in the world for years. Their contribution to global growth has eclipsed even the US for years now because even though their economy had been smaller (it’s not any more) than ours, China was growing several times faster. They went on an extraordinary–I mean really extraordinary–buying and building binge over the last 20 or more years. A December 2014 Forbes article (citing Bill Gates’ blog) covered China’s building boom from 2011-2013. The headline read:

China Used More Concrete in Three Years Than the US Used in the Entire 20th Century

Because they consumed so many raw materials to build the infrastructure they needed (and some they didn’t need), two things happened:

1) They led the world to believe that it was a sustainable trend and so the world borrowed and built to help satisfy China’s appetite, and

2) China themselves became addicted to growth and more comfortable with debt, making a potential slowdown more likely to be severe.
So the question is whether 1) China is sneezing and 2) whether the world economy has caught the flu–or even something more debilitating.

The answers are yes and yes.

The first part of the question–as to whether China is in any trouble–is not easy to assess, but the stock market of any country acts as a discounting mechanism—it forecasts. And the Shanghai Index has been in crash mode lately. According to a September 2nd Fortune article last year, though the Chinese stock market has much small-investor participation, it is still dominated by the biggest (read ‘insider’) players. Because insiders are more likely to read the writing on the (great) wall, when I see selling in China, the fortune-cookie message reads “He who sells before trouble buys later for a double.” [Okay. Enough China puns.]

The second part the question–whether the US will be affected–is not much easier to answer. Many pundits—Fed Governors included–think the US is insulated. But when you consider the impact of the sizable debt used (here and in emerging markets) to fund the energy and raw materials extraction, the impact of a slowdown is increased. Oil and other key resources are not merely components of production anymore; for much of the developing world, they are income, wealth, and collateral.

In an integrated world economic system, everybody is in it together. This is known as “systemic” risk. It’s one of the drawbacks of specialization and free trade that you don’t hear about in Economic Theory 101.

Is it the flu or something worse?

It’s at least the flu. The global economy is probably in recession as I write this. The US has some insulation because we do not rely on exports as much as other G-7 nations. And the US consumers benefit from lower energy prices. Yet we are highly leveraged as a society and we (and our government) have been relying on borrowing cheaply to drive our economy. If we see a debt crisis spurred on by defaults in sovereign and energy debt, the US economy will reel from it. We also rely on wealth-effect growth. This means that when pension funds and 401k accounts, nest eggs, and real estate go up in value, we feel “flush” and spend more. When stocks and bonds and real estate, etc. go down, we cut back spending—and pensions become underfunded, causing state and municipal budgets to shrink. All bad.

What should people do?

In another month, when they celebrate the New Year, the Chinese will usher in the Year of the Monkey. Pretend it isn’t happening, and maybe it will go away.


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