China Overly Blamed for Global Market Malaise

It has been a perfect storm for global financial markets. But the components of the storm are so varied that there will be no unity of opinion on the aftermath.

Some of those components may be oversold others merely at the start of a long malaise. If there is a common denominator it is exaggeration of China’s role. Although China remains a partly closed economy, foreign markets have massively over-reacted to Beijing’s moves – for example the Aug. 25 cut in interest rates – saw New York briefly rebound by 2 percent until it was deemed more evidence of weak Chinese demand and suggesting further currency devaluation.

The components are:

  • The unsurprising end of a credit- and official exhortation-fueled China stock boom focused particularly on secondary and supposed tech stocks.

  • The continued decline of oil and commodity prices. That is more the result of supply increases than demand falls but China got the blame and stocks and currencies of commodity exporters fell.

  • China’s modest devaluation set off a fears of a global currency war which would damage all economies. So-called emerging market currencies have suffered again even if they have been beneficiaries of low commodity prices.

  • Generalized fear that China’s days as leader of world growth are over and hence the world which has been benefiting from Chinese demand is in for harder times. Deflation looms almost everywhere, a particular hazard to markets used to inflation and low real costs of money

  • The prospect of higher US (and other) interest rates. This is deemed to be bad for stocks generally and especially bad for emerging markets which have been fueled by borrowed dollars.

  • The strong dollar and its impact on earnings of US companies, exposing the unrealistically high valuations of the US market.

  • The failure of Japanese Prime Minister Shinzo Abe’s policies in Japan to stimulate demand, which have pushed stock prices to the point where reaction only needed a spark

  • Europe’s papering over of the Greek crisis plus a weak currency, which has produced outsized gains on once-depressed Euro markets, which invited reaction.

So there are interlinked themes but plenty of room for the future to be more divergent.

Take China. It is abundantly clear that China is not growing at anything like the 7 percent officially claimed and that it should be content to settle for a consumption-led 4-5 percent. That is the best that can be expected from an economy saddled with so much domestic debt and over-investment in low return projects.

Exports are no longer an option as global demand is weak and a major devaluation would spark retaliation and more market turmoil. Many Chinese stocks have been prevented from falling by suspensions and official support. These have further to fall given that the Shanghai index is still above a year ago. That said, however, some of the big, boring state-owned behemoths are no long looking expensive, at least by their prices in Hong Kong, where discounts to mainland A shares are still substantial. Selective bottom-fishing may be advised for those who can stand more short-term volatility and perhaps another big sell-off.

The situation of Asia’s biggest losers Malaysia and Indonesia could not be more different. Both have suffered simultaneously from the collapse of commodity prices and the generalized scare about emerging markets. Malaysia has added to its woes with scandals and political turmoil which have trumped the fact that it still runs a current account surplus. Its 35 percent currency collapse is reflective of politics as much as economics.

In Indonesia, the commodity collapse has presented President Joko Widodo with a difficult hand to play. The 29 percent decline in the currency has been unsettling and probably excessive. Indonesia’s current account deficit is manageable, there is no big foreign debt overhang as in 1998. The trade account is sensitive to the currency so the deficit is unlikely to widen. There is still plenty of footloose funk money still wanting to exit emerging markets like Indonesia and domestic demand growth will be curtailed by higher import prices and ambitious infrastructure spending by Joko will not come soon enough to offset this. So a big bounce in shares or currency looks likely.

Nonetheless, rational assessment suggests the risk-reward ratio is attractive for long term investors. The same will only apply in Malaysia when there is some light at the end of the UMNO tunnel.

Developed commodity exporters have suffered less although the Australian and Canadian currencies are both down 25 percent over a year. But the full impact of commodity prices on their overall economies has yet to be felt and in Australia some sectors such as Sydney property are still in bubble territory.

Another property bubble facing deflation is Hong Kong, where the US currency peg will add to woes from China with further falls in tourism and retail sales and probably a decline in financial services. Should the US interest rate rise materialize, a sharp retreat in property prices looks inevitable and may well happen anyway.

Everywhere in the world, the prospect either of deflation or the end of cheap money or both hangs over markets. Overcapacity in manufacturing as well as materials is likely to persist for some time, particularly if China stimulates the wrong sectors.

But the losers now are likely to be those with the strongest currencies. US earnings are already suffering from the strong dollar yet the markets are still priced well above historical averages in the face of a profits squeeze and the probability of interest rate rises. At the very least they are unlikely to benefit from the buybacks that have boosted prices over the past two years.

Japan and Europe have probably already benefited as much as they are going to from the declines in their currencies. Japan’s domestic demand remains static and while Europe is recovering slowly, most of that may already be reflected in stock prices.

The Taiwanese and South Korean currencies have adjusted downward by 10 percent and 19 percent respectively, about enough to maintain competitiveness , but sentiment will remain heavily influenced by the China outlook. Northeast Asia overall has big surpluses of capacity in many industries.

Neither Taiwan nor Korea has much scope for domestic demand growth given their weak demographics and, in the case of Korea, high household debt. Nonetheless their stock markets are not highly priced and both countries continue to enjoy large current account surpluses.

Indeed, for those looking to sleep comfortably, Taiwan has one of the least volatile markets and currencies on the planet. Yet with stocks down 15 percent over a year it has been almost the worst performer in Asia. That looks like one of the bigger of the many anomalies to have surfaced recently.