Why is China Driving the US Stock Market?

Uncertainty and the impact on the global economy make China a major factor

 

China isn’t the only reason US stock market plunged last Friday. But it was a big reason and may have been the catalyst for the fall. This isn’t because of a direct link between the markets—due to capital restrictions, foreigners own a relatively small portion of the Chinese stock market and the Chinese own a relatively small portion of foreign stocks. Rather, China’s influence on the US stock market is exerted by its role as the second largest economy in the world and the impact it has on confidence in the global economy.

 

 

Bad news relative to a slowing economy

The preliminary Purchasing Manager’s Index (PMI) for August fell to a six and a half year low of 47.1 (a score of 50 or above means expansion while below 50 indicates contraction ahead.)   China’s economy is transitioning from the days of export and investment driven growth that averaged 8-10% per year to an economy built more on technology and domestic consumption which is likely to grow at a more reasonable 5-7%. This year the goal was 7% and the recent PMI reading is simply the latest in a long line of indicators that suggest growth might be much slower than expected this year. China has already, on multiple occasions, tried to stimulate growth via interest rate cuts and other measures but nothing has worked, which further saps confidence.

 

A damaged stock market

In June, after more than doubling over a twelve month period, China’s stock markets plunged by more than 30%. The government countered with massive intervention that suspended the fall of the market but not the fall in the confidence of investors. The market has since bounced up and down, leaving investors with the impression that the only reason the market rises is because of the government. Earlier today (Monday), the Chinese market plunged by 8%, confirming the overall sense is that, without the government, a further fall is highly likely.  Investors seem to be lining up at the exit to get out of the market.

 

Currency devaluation

On August 11, after engineering a rise in its currency over the last decade and intervening directly to support its currency over the last year, China allowed its currency to devalue by 2%. The initial devaluation was not large, but it raised few concerns. First, is China going to devalue its currency even further, possibly igniting a currency war? Secondly, is China so concerned about growth that it would use a massive currency devaluation to try to spur exports? If so, does this mean the rest of us should be worried as well?

 

Debt and capital flight

In the aftermath of the Global Financial Crisis in 2008-09, China has relied heavily upon debt-fueled investment to maintain growth. Debt to GDP has grown from a moderate 120% to a risky 280% or more, the side effects of which include over building throughout the country, a real estate bubble, and a stock market bubble. Not only does the rapid increase in debt bring the risk of a credit crisis, it also adds to the risk of capital flight from China, which will make it harder to manage everything else, including the stock market, currency, and overall economy.

 

Markets don’t like uncertainty

Economic forecasting is never certain. But when the economy is a mixture of free market capitalism and state-controlled communism and the government is not known for transparency, the uncertainty is rising tremendously. China is difficult to understand and assess which simply adds to the uncertainty surrounding its economy. Many don’t trust China’s own economic statistics and think China’s economy is already much slower than they admit. Because China’s policies are often not completely in line with free market economies, investors don’t know what to expect next. When will the government stop propping up the stock market? What will the impact be? What are China’s intentions relative to its currency? Is a currency war right around the corner? Answering questions like these is more difficult with China than it would be with a more mature, market economy.

 

Bad news relative to an already weak economy, a falling stock market in suspended animation, a currency devaluation that looks desperate and may portend a currency war, and a looming debt crisis. If China’s economy was the 20th largest in the world, and not the 2nd largest in the world, the markets would probably not care. But given China’s global impact, no wonder everyone is a bit worried.