The problems keep piling up in China. Weakening demographics, as her population shrank for a second consecutive year. Weak consumer spending. A record property downturn. Rising trade tensions.
The drip-drip-drip of these glitches culminated in a massive stock market wipeout as over US$6 trillion has been wiped from the combined capitalization of the Chinese and Hong Kong markets since the 2021 market peak. As an illustration of the depth of the carnage, the Hang Seng Index fell to test levels seen at the 1997 handover to China. Beijing responded with a plan to order State Owned Enterprises to use its offshore currency reserves, which is estimated to be 2-trillion yuan, or US$278 billion, to buy Chinese stocks to prop up the market. In addition, the PBoC announced a half-point cut to the required reserve ratio on February 5 to provide greater liquidity to the financial system.
For investors, the key question is what’s the effect of skidding stock prices in China and nearby Hong Kong on the rest of the world?
Estimating the contagion effects
I don’t pretend to understand the Chinese stock market, as its price action is often unrelated to the economy. Nevertheless, investors can use the real-time market signals of the stock markets of China’s major Asian trading partners to estimate the effects of the latest market wipeout. The accompanying chart of the relative performance of these markets to the MSCI All-Country World Index (ACWI) shows that, with the exception of Japan, Asian markets are all weak.
As China is a voracious consumer of commodities, commodity prices represent another real-time barometer of the Chinese and global economy. The message from commodities is less dire than the one from Asian markets. Commodities are weak, but stabilizing. More importantly, the cyclically sensitive copper/gold and base metals/gold ratios are flat, indicating no significant signs of weakness in the global economy.
The choppy sideways action of the copper/gold and base metals/gold ratio as an indicator of the global cycle is confirmed by a similar pattern in the global consumer discretionary to consumer staples as an indicator of global risk appetite.
Where to hide?
Where can global equity investors hide from China’s latest wipeout? The accompanying chart shows the relative returns of major global regions and their correlation to the Chinese stock market. The most uncorrelated market to China is the U.S., which has shown a history of negative correlation to relative price movements to China. The relative returns of Europe and Emerging Markets ex-China are correlated to China, indicating higher sensitivity to the Chinese economy.
The accompanying chart shows the relative returns of global regions. The U.S. continues to show leadership. China, Europe and EM ex-China are weak. Japan is basing and trying to stage an upside relative breakout in USD terms as the Nikkei Average has risen to new recovery highs in JPY terms.
This suggests that investors should look to the U.S. market as a way of insulating their portfolios from China’s problems while avoiding other major regions. However, more detailed analysis indicates value opportunities in Europe and washed-out China.
The accompanying chart shows the relative returns of the financial sector by region. If financial stress is rising in any region, it would show up in the relative performance of their financial stocks. While U.S. financials are trading sideways on a relative basis, the surprise is the steady relative uptrend of European financials and the strength of Chinese financials in the last two months. I interpret this to mean possible stabilization in China, and value opportunities in European equities, especially in light of market expectations of the first ECB rate cut that begins in June.
In conclusion, problems have been piling up in China and culminated in a record property downturn and stock market wipeout. My estimate of the contagion effects indicates that Chinese weakness will not crater the global economy, but it has weakened the performance of European and EM ex-China equities. U.S. stocks appear to be the most insulated from China’s problems. Value investors may want to consider exposure to Europe as a turnaround play.
The last couple of days saw a big jump in copper and other base metals when news of China government support hit. The charts above showing them would look very much weaker without those two days. I expect that was short covering in the commodity futures market. The big jump in Chinese indexes did not produce a TWIST this week to my surprise. The high momentum side of the index went up more than the low. This shows investors have little confidence in a real start of a significant intermediate up cycle or the bottom of their bear market. At a real low, the beaten up and bargain priced low momentum stocks surge up dramatically and lead for months. In summary, this is a rally in a bear market until we see a TWIST.
Richard Koo would say the Chinese ‘Balance Sheet Recession’ will continue regardless of the governments reduction of bank reserve requirements. He would say, “If people don’t want to borrow, giving them a greater amount to borrow won’t get them to borrow and spend to boost the economy.” I urge everyone to watch a Richard Koo Youtube video to hear his theories. Or better still, his recent book.
China under Xi is a curious case. Chinese in general are resilient and shrewd. Over thousands of years they have gone thru the most turmoils you can imagine. Yet they survived all these dramatic changes. But they have met their match in CCP. The last several years can be described as desperation and hopelessness. Chinese don’t want to spend and they can’t put money in banks because the deposit will disappear. Gold possession is one alternative but is limited. So now the underground remitting industry is growing into a gigantic scale. A lot of operators are in Taiwan. A short while ago I visited my parents in Taiwan and met a few operators. Really eye opening. US gov is happy to see capital being siphoned out of China and actually complicit in aiding it. Bitcoins exist for a reason. It is a conduit thru which very valuable info can he obtained across the globe.
expectations of the first ECB rate hike that begins in June ??
I think he meant to say rate cut?
Sorry, typo