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The Pain of Reform and China's Economic Rebirth


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The Pain of Reform and China's Economic Rebirth

  1. 1. Tom Shaw Investment Newsletter | Q3
  2. 2. 1 This past quarter, market news continued to be dominated by information on falling commodity prices, the Chinese correction, and most recently, the economic fallout of the FOMC decision to maintain current rates. While these factors are certainly interdependent, I will focus on the Chinese timeline and its subsequent effect on market movements and volatility. It may be difficult to remember a time before fear of a Chinese contagion, but the Chinese stock market reached a record high as recently as June 12th this year. Of course, since then, the MSCI ACWI and MSCI Emerging Markets indices – two key benchmarks used to measure the global equity market and emerging equity market – have fallen 7.564% and 16.003%, respectively as of September 16, 20151 . These numbers are certainly substantial, and I believe it is important to understand the factors that led to such a quick and volatile correction. Figure 1 – Shanghai Composite Index movements and drivers since November 2014 1
  3. 3. 2 Modern China’s Emergence To provide context, China did not truly begin to emerge in the global marketplace until 1978, the year Deng Xiaoping, the former leader of the People’s Republic of China, introduced “Socialism with Chinese Characteristics”, reopening China’s doors to foreign investment and aggressive infrastructure growth. Following the model of many other East Asian countries, China primarily drove that economic growth through importing cheap labor from the countryside into the global supply chain – this supported economic growth two-fold by efficiently allocating resources from agriculture to the higher value-producing manufacturing sector. With such a large labor surplus, the Chinese economy grew around assembling high-end components from developed nations and exporting those products, while building the infrastructure to support that growth; however, in order to sustain that growth, the economic model requires exports and the labor surplus to continue to grow – two assumptions that no longer hold true. Chinese export volume is beginning to decelerate2 , a trend relevant to the recent devaluation of the yuan, and the labor force is shrinking with an aging population, no doubt in part due to the One-Child policy that began in the 1980’s. To support this notion with data, for the past 15 years China has enjoyed an average GDP growth rate of 9.413%3 . However, this figure is a bit misleading in that China’s GDP growth has hovered between 7.4% and 7.7% for the past three years, indicating that the slowing growth in the world’s second largest economy is not a new development. It’s in this sense that China’s story diverges from the emerging markets template where an improving economy feeds corporate earnings, which induce further investment (or in this case the opposite). Here, China is more analogous to the Eurozone, where a slowing economy can still support a good stock market. 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 7.620 8.431 8.300 9.082 10.025 10.085 11.310 12.677 14.162 9.635 2009 2010 2011 2012 2013 2014 [2015] [2016] [2017] 9.214 10.600 9.300 7.653 7.671 7.436 7.121 7.037 6.887 Figure 2 – Chinese GDP Growth Percentage measured in 2010 USD [2015 – 2017 figures projected] 4 Economic Reform By necessity, China is now beginning to adapt its economic model to these new conditions, and like any young economy, is suffering through growing pains as it shifts to household consumption as a primary demand-driver. As has been repeated ad nauseum here at Baystate, the term “correction” means “to fix.” The prudent question then arises, “What is being fixed?” In this case, the changing Chinese economy is naturally leading to fundamental economic reforms to past tailwinds that are now shifting direction, such as excessive credit growth, the misallocation of capital, and the aging industrial base. The timeline of these financial, fiscal, and 2 3 4
  4. 4. 3 Figure 3 – Correlation matrix of the Shanghai Composite Index with other Major international indices administrative reforms have certainly accelerated in reaction to the equity market volatility, with the devaluation of the yuan a chief example of increasing currency flexibility5 . Inefficient Markets So why is the Chinese market correcting at the same time its underlying economy is moving past the factors that led to decelerating growth three years ago? In my research, the only consensus is that there is no consensus; however, one through-line seems to be the unusual nature of the Chinese equity market relative to the equity markets of developed nations like the US. While major national indices like the S&P 500 tend to respond to the economic state of the country, the Chinese equity market, and specifically the A-share market that only trades on the Shanghai and Shenzhen stock exchanges, is not highly correlated with China’s economic health. Some of this disconnect may be explained by the domination of retail investors in China. Unlike other major stock markets that are heavily influenced by the actions of institutional investors and professional money managers, China’s almost 200 million retail investors, about two-thirds of whom never finished high school6 , account for around 85% of Chinese trading volume7 . With so much activity driven by the enthusiasm of unsophisticated investors that may have believed the Chinese government would continue to prop up equity markets, the faltering faith in government intervention and ensuing panic have led to aggressive selling and a significantly diminished level of trading volume, an indicator typically associated with the efficiency and volatility of a market. Coupled with the growth in margin trading, a few bad bets can result in significant downward pressure as investors are forced to liquidate assets to fulfill margin calls. Conclusion However, there is still reason for optimism. As mentioned previously, China is a young economy that is going through the necessary growing pains to ensure it continues to develop in a healthy direction, and the recent sell-off has further compressed valuations making future investment more attractive. Despite the high volume of retail investors in the Chinese market, equity investments represent less than 15% of the average household financial assets, meaning the market downturn should have a minimal effect on household consumption and aggregate demand in the Chinese economy8 . More importantly as it relates to investors in the US, China’s equity market has historically seen little correlation to other major global markets, and foreign investment quotas have limited any meaningful financial integration9 . China’s economy is the second largest in the world and the country has trade ties to virtually every major developed nation, but the same 5 6 7 8 9
  5. 5. 4 capital controls that limited foreign investors from directly benefiting from one of the best performing geographic sectors last year is also buffering us from the current volatility abroad. By no means,do I want to suggest that the problems in China will not have an impact on US investors. I have already mentioned the recent performance of the MSCI ACWI and MSCI Emerging Markets indices that have no doubt been heavily influenced by China’s financial pains, both directly and indirectly. The purpose of this report is to provide some insight on the underlying fundamentals of the Chinese economy, and how we are looking at a unique time in this nation’s efforts to emerge as a developed nation on the world stage. This report contains the opinions and views of Tom Shaw. While Tom Shaw is an employee of Baystate Financial, the views and opinions expressed herein are their own, and do not necessarily represent the views and opinions of any other employee or representative of Baystate Financial. This report is not intended to provide investment advice and no one should rely on the views and opinions expressed herein in making investment decisions. All recipients and readers of this Report must consult with and rely on their own investment professionals in making investment decisions or when buying or selling securities of any type. Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Baystate Financial), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Baystate Financial. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Baystate Financial is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice. There is no guarantee that any forecasts or opinions expressed in this event will be realized. Information should not be construed as legal, estate tax, retirement or financial planning advice. These opinions do not necessarily represent the views of MetLife or any other person in the MetLife organization and are subject to change at any time based on market or other conditions. L0915439547[exp0616][AllStates][DC,GU,MP,PR,VI]