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29 July 2015

China - Equities and Commodities

Should we be seriously concerned about the recent gyrations in the Chinese equity markets? A huge (150% plus) rally, followed by a thirty-odd percent drop, and a raft of Government measures put in place to try and slow the decline. Is it telling us something about the underlying state of China’s economy, the world’s second largest? Or is it a just little local difficulty, a storm in a cup of oolong? Commentators seem divided, although certain things don’t appear to be disputed. First, the stock markets in China are primarily about speculation, rather rather than having the traditional focus of raising capital for company expansion and development. The extent of overall exposure is rather limited; although the absolute number of investors looks quite big, in terms of percentage of the population, it is not - certainly, it’s below ten percent. The bulk of stocks are held for a short period of time - the implication of that is that we are talking about a short-term approach rather than long-term value investing. On top of that, after such a strong rally, most of us would probably regard a sell-off to blow away some of the froth from the market as possibly even a welcome steadying influence. 


But the Government does appear to be quite seriously concerned, if we consider the lengths they have gone to to try to prevent sellers from getting the upper hand. Maybe because margin investment is undoubtedly a feature of this market, although it is quite difficult to see reliable numbers. However, the best estimates that I can find suggest that the margin debt is not in fact at a seriously threatening level. Yes, there would be pain in some quarters, but not - seemingly - enough to cause further instability. It really does look like the old, old story of a speculative market getting ramped up and up, then the bubble bursting and the market dropping as fast as it went up (or faster..). The numbers are big, but it’s a big economy; the headline-grabbing figure is that the loss of value for peak until now is the equivalent of the value of the entire Paris Bourse. Sounds a lot, but in context, it’s uncomfortable rather than economy-threatening; and bear in mind, the index is still higher than a year ago.

Better Indicators

There is something potentially threatening going on, though; it’s just that there is a far better indicator than the stock market. Chinese growth is slowing dramatically. The way to see that is not by looking at that stock market, with speculative froth blowing around it, but to look at commodity prices which, given the dominant position China now holds as a buyer and consumer, present a far more realistic picture of that slowdown. I’ve written about iron ore and oil before, and the way that dominant producers are maintaining production to squeeze competitors and expand market share; the other side of that coin is that demand overall has dropped sharply, precisely giving them the leverage to execute their strategy. And the biggest drop in demand is coming from China. Base metal prices are heading in one direction only at the moment - downwards, because of the same phenomenon of declining demand from China. Commodity prices are showing the real measure of the slowdown, not the stock market decline which in comparison is a sideshow.

International Implications

How this will play out internationally, given the importance of China’s economy, is not clear. Parts of the western economies have come back from the 2007/08 crash perhaps better than could have been expected, although are by no means made whole again. Shale oil and gas in the US are a major factor; the reduction they have brought about in US manufacturing costs has boosted that economy substantially. To that extent, Obama is a ‘lucky’ President. Likewise, although at heart it is a highly dubious policy, QE as practised by the US and the UK has rolled problems forward, making the present look more attractive. Make no mistake; the problems are still there, but pushing them away through QE has bought breathing space. Whether those two factors can outweigh the slowdown coming from the East is uncertain. One thing that is certain, though, is that the much-heralded date when China overtakes the US to become the world’s largest economy is getting further away, not closer. 

And here’s another thought. All those who have been predicting China’s imminent move to an international, gold-backed, quasi-reserve currency Yuan, you may have to hold your breath longer than a free-diver. They’ve got problems to solve first.

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