Predicting Unpredictability in Chinese Equity Markets

Richard B. Evans, Dennis T. Yang and Dave Hendrick ,

The explanation for the global market turmoil seen in January often seemed to come down to one word: China.

The precipitous decline of Chinese stock markets to start the New Year, as well as rapidly declining faith in Chinese leaders’ abilities to boost, or even stabilize, investor confidence, led to a significant sell-off in equities in China and around the world.

If the events of recent weeks sounded familiar, they should, as they harken back to the Chinese equity market crash in late summer 2015, when a long run-up in markets gave way to sharp declines and panicked retail investors.

So, will the fallout from the events of early 2016 be meaningfully different than 2015, when the panic of September gave way to an October calm?

While that question is difficult to answer with certainty, Darden Professors Dennis Yang and Rich Evans, both long-time China watchers, posited some explanations for the events in China — as well as expected impact on the U.S. market — during a recent presentation to Darden alumni. The material is familiar territory for Yang and Evans, as they offered similar presentations following the September turmoil.

Yang recounted some of the factors behind the recent tumult, including slowing economic growth in China, a devalued currency and skepticism surrounding government intervention in the market, among other triggers.

Indeed, the latter factor may be particularly acute this go around, as efforts to install so-called “circuit breakers” into the market to stave off precipitous drops were scrapped shortly after being instituted, as the mere presence of a guard against freefall seemed to add to investor pessimism.

As Chinese and global markets continue to wobble, Evans and Yang made clear that there did not appear to be easy answers as to how to avoid the turmoil.

“I wish I could say here is the silver bullet that is going to fix these things or help protect you from the volatility,” Evans said, referring to the multiple factors that have led to the market upheaval and noting some of the structural reforms that were widely expected to decrease market volatility, but have done anything but so far.

Yang agreed that China represented a particularly tough market to accurately predict or advise about given the heavy hand of market intervention.

“It’s pretty hard,” Yang said. “In other more mature markets, people consider that there are fundamental factors and there are a higher percentage of institutional investors.”

Left without the typical benchmarks and measurements used to decipher the Chinese markets, investors and market watchers both end up operating in large part on speculation.

Regarding the value of China’s currency, which the Chinese government devalued in 2015, Yang said that while also hard to predict, he would not be surprised to see some continued devaluation of the Yuan.

Although the Chinese government has an interest in perceptions of currency strength and stability, if growth continues to slow, Chinese authorities also have the incentive to devalue the Yuan in order to boost exports, Yang said.

If further devaluation occurs, it will likely happen gradually, Yang said, adding that China’s huge dollar reserves can facilitate a controlled, planned process.

The impact of China on the U.S. economy and equities, too, is difficult to predict, but given declines to start the New Year, Evans suggested the turmoil in China may have been a signifying event for investors already concerned about arguably frothy valuations in equity.

Said Evans, “Perhaps U.S. stocks were overvalued to some degree, and even if the Chinese stock market didn’t have as direct a connection to U.S. GDP, it enabled sophisticated institutional investors to coordinate their exit.”

About the Faculty

Richard B. Evans

Professor Evans’ research and teaching focus is investment decision-making. He explores risk taking by mutual fund managers, the role of broker intermediation in mutual fund investing, the impact of commission bundling and other trading costs on portfolio performance and retail and institutional-investor behavior.

Evans has been cited by The New York... Learn More

Dennis T. Yang

Yang is an expert on China — its labor markets, financial systems and phenomenal growth, which have made it an economic contender. His broader research expertise includes economic development and growth, comparative economic systems, as well as labor and demographic economics in the context of emerging markets. A native of... Learn More

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