Thirty years ago, Shanghai was a quiet city. Occasionally, a truck would trundle down the somber, hand-swept streets, though most goods were transported by handcart or heavy steel-framed bicycles. People walked or pedaled about, with the rare car reserved for the highest officials. Busses belched along, filled to capacity, no traffic jams to slow their progress. Few cranes loomed about, as construction sites were noted for their bamboo scaffolding and lack of mechanization. And thirty years ago, in 1985, the Shanghai Stock Exchange remained closed in deference to the communist system that had come to power in 1949. The Exchange would not reopen until the end of 1990.
Since that reopening, the Shanghai Exchange has been busy. By May 2015, the Shanghai Stock Exchange was the fifth largest stock exchange in the world, with a market capitalization of over US $5 Trillion, though roughly two-thirds of that market cap weight had been created by highly leveraged trading over the previous one year. Since peaking in June 2015, the Shanghai market has declined by over 40% causing the spilling of no small amount of digital ink; however, even with that sharp decline, the Shanghai market remains up almost 30% from one year ago. But whether one gathers news from NPR or Fox or points between, much media frenzy has been made of this decline, shoving the Shanghai Exchange into a spotlight inconsistent with its relevance in the Chinese—let alone global—economy.
The Shanghai market (and its attendant volatility) clearly has impacted investor sentiment, drawing attention to concerns over a Chinese economy that, while growing, is slowing its pace of growth and showing other signs of stress. Some fear that China might be due for a hard landing, that is, a harsh slow down of the economy so dramatic that it tips the Chinese economy into recession. We firmly believe that economic fundamentals ultimately drive a market in the long-term, but in the near-term, behavioral factors and market idiosyncrasies can create tremendous anxiety. As such, while we do not see the data out of China predicting a Chinese—or global—recession, it remains important to consider how behavioral, market, and economic drivers play into the current unease.
1) Confirmation Bias
“Confirmation bias” describes that all-too-human tendency to seek out the facts that confirm our beliefs, while ignoring the facts that run counter to what we want to accept as true. Currently, there are market commentators who seek confirmation that the world is teetering on the edge of catastrophe, that global economic collapse is imminent. Some of the most ardent voices are selling gold, pitching books, promising risk parity, or pursuing political aspiration. Many concerned investors, however, simply figure that we are due for a correction after six years of steady returns that have outpaced growth and six years of modest volatility that has underrepresented risk.
For many of these investors, the sell-offs of 2000-2002 and 2007-2009 still loom fresh in their memories. They find in the Shanghai market’s downside volatility evidence that their expectations of further carnage are correct. The situation is compounded by other data points such as China’s currency devaluation. After years of China intentionally using purchases of US dollars to limit the appreciation of the Yuan in order to support Chinese exports, China recently introduced more uncertainty into currency markets by allowing the Yuan to depreciate versus the US dollar. While the move has been in the low single digits, the way the devaluation was announced accentuated the lack of transparency of Chinese economic policy and heightened short-term volatility. Still, we expect that the long-term implication of China allowing its currency to be more accurately reflected in the capital markets will prove a positive condition.
Investors insistent on seeing economic bitterness in the tea leaves might minimize contrary data points about the Shanghai market and Chinese economy, such as:
- Foreign investors generally are not allowed to invest in the Shanghai market, thus insulating to some degree foreign investors from the sell-off;
- Fewer than 10% of the Chinese population has a trading account, reducing the negative impact of that market’s sell-off on Chinese consumers;
- Much of the market value in the Shanghai Exchange has been due to leverage that has amplified the gains and now amplifies the losses, underscoring that speculation—not long-term economic value—has been punished by the sell-off;
- The Chinese economy and Shanghai stock market are largely distinct, even more so than markets and economies in the United States or in Europe; thus, the Shanghai market declines represent not a cause of China’s real economic challenges, but more a symptom of a maturing system going through a complicated transition.
The easiest thing to do in investing is to seek and find the data that validates our opinions; effective economic analysis, however, requires that we form opinions only once we first have cast a broad and precise net on the data. Doing so makes it much easier to consider how to manage the risk of even relatively immature markets.
2) An Adolescent Market
The volatility extremes of 2014-2015 illustrate China’s efforts to develop a more mature, locally-driven stock market to manifest at least some of the unbounded optimism generated by China’s rise. Opaque government regulation and intervention that is corrupt and untrusted have contributed to the volatility. Market maturing efforts tend to be clunky regardless of where and when they take place, whether 1930’s United States, 1990’s Russia, or now in China. Given that China has become the world’s second largest economy and given that media communicates information (and misinformation) in a steady 24/7 stream, China is experiencing these growing pains under the world’s microscope.
The Shanghai Exchange might be a young adolescent, but the expectations placed on China by the global economy require that it grow up very quickly. Regulators must provide clearer rules for trading on the market, particularly when using borrowed funds. Clear limits on the use of leverage will help reduce volatility. The government must be clear about whether or not it will buy stocks to prop up the market, the triggers that will instigate such buying, which companies it will support, and on what terms. And in time, the Shanghai Exchange should not just allow, but seek, the investments of institutional investors outside of China, especially pensions and endowments that invest directly or via money managers. That institutional money tends to be more patient than retail money and would help stabilize the market. Just as the American exchanges have evolved over time—often in response to crisis—the Shanghai Exchange must take the next steps necessary to be a true marketplace, one that better reflects the promise and reality of the Chinese economy.
For the Shanghai Exchange to mature, however, it will require similar evolution across Chinese policy makers, and especially from the People’s Bank of China. The irregularities and inconsistencies of the Shanghai market merely reflect larger governance issues that pervade the Chinese financial system. As the system earns greater confidence at home and abroad, the markets—and more importantly, the economy—will stabilize and strengthen.
3) The world’s most robust major economy
Investors around the world sense that China has become terrifically important to global growth and investment markets, rendering weakness in China significant to all of us. And to a large degree, they are correct. China IS terrifically important. But recent Shanghai market performance is more about that market than it is about the broader Chinese economy.
China rapidly has become the second largest economy in the world, with a GDP of about $10.4 Trillion (US Dollar), while the US sits at about $17.4 Trillion (US Dollar). Combined, Japan and Germany come in at about $8.5 Trillion (US Dollar), rounding out the top four countries by GDP. Whether growing at 7.0% (Chinese government data), 6.6% (Bloomberg estimate), or something as low as 5.0%, China’s growth rate is compelling for an economy of its size. Some lament that China no longer grows in the 10-15% per year range as it did from 1980 – 2010, but an economy of its size growing at that rate would be far too hot. Solid mid-single digit growth is appropriate and meaningful. The current growth rate represents somewhere in excess of three times the US economy, five times the European economy, and many times greater than the Japanese economy.
Some note that China’s Manufacturing Purchasing Managers Index (“PMI”) is contracting. Considered in isolation, that data point could be a harbinger of long-term Chinese stagnation or even decline. That the Services PMI is expanding at the same time gets far less attention. Taking both data points into account leads to some compelling questions. What if the lower Manufacturing PMI data indicates that China is shifting from a heavily industrial manufacturing based economy to one driven more by consumers and services? What if it is a sign of a maturing economy becoming less dependent on commodities and external consumers and more dependent on its local consumer base? What if that shift means more Chinese consumers buying more goods and services from companies around the world?
Actually, for the last two years, China has been making that shift, with household consumption becoming a larger part of the economy than fixed asset investment, a sign that consumer spending has become more important than industrial production, though at this point, both are critical to China’s growth. Understood in that light, the Manufacturing PMI decline reflects not new news or bad news, but rather a long-term trend reflecting a normal and necessary transition—one good for China and ultimately good for the global economy.
Time to Buy? Time to Sell?
August 2015 has been challenging for risk assets. Many equity markets are in correction territory (losses > 10% from peak levels), credit spreads have opened significantly, and yet, many investors welcome the volatility as long overdue, almost as if it were a stronger sign of health than pervasively low volatility and stagnant markets. While some market environments create more obvious buying and selling conditions for long-term investors, this market remains murky. On one hand, recent selling has not created such obviously cheap market segments that it’s a ripe time for bargain hunters. On the other hand, fundamental data still signals generally positive information, making it harder to sell into already stressed markets.
In the United States, companies and consumers are healthy, with strong balance sheets, cash on hand, and reasonably strong confidence levels. There are not major market excesses as there were in 2000 and 2007. The Fed faces a big challenge with respect to how best to raise rates precisely because so much economic news is reasonably positive. Concurrently, Europe is clearly on the road to recovery. Corporate health is improving, bank lending to both business and consumers has picked up, and the European Central Bank is developing the policies and practices necessary to more effectively guide the economy. Assuming that the US and Europe can steadily if slowly expand growth, and assuming that China can effectively navigate its secular economic shifts to maintain its strong single digit growth, then investors can find ample opportunity for modest long-term income and appreciation, accepting of course, the commensurate uncertainty along the way.
Just as Shanghai once was a quiet city, investors these past several years have become too accustomed to too-quiet investment markets, markets in which risk assets generally have risen without requiring investor research, discipline, or patience. Perhaps it is fitting that the excesses of the stock market in Shanghai—a city no longer quiet—should remind us that investing demands courage, thoughtfulness, and humility. Thank you, Shanghai, for the affirmation.