“China Fears Sink Markets Again,” heralded The Wall Street Journal headline on 2 September.
That the precipitous decline of the Shanghai Composite Index — down roughly 40 percent from June through early September after eight months of similarly dramatic gains — was rattling global markets is not news to the financial world. However, the causes of the Chinese turmoil and reasons why it is causing a ripple effect across global markets are more opaque.
However, University of Virginia Darden School of Business professors drilled down to the heart of the matter during two special sessions at UVA in September — first at a Flash Seminar hosted by the University and open to all students, then at a session of Darden Academy, an optional learning enrichment program. Combined, nearly 200 students attended these two sessions.
Dennis Yang, the Dale S. Coenen Free Enterprise Professor of Business Administration and academic director of Darden’s Asia Initiative, and Rich Evans, associate professor of business administration, co-led the sessions, and Kieran Walsh, assistant professor of business administration, served as a panelist at the Flash Seminar. The events detailed the forces swirling around China’s market decline and challenged the conventional wisdom about the Chinese turmoil’s impact on U.S. markets.
Yang identified potential triggers of the Chinese market decline, which included:
- Slowing economic growth in China, which has been reflected recently by declines in China’s manufacturing activity and total volume of exports and imports relative to the same period last year
- Asset allocation away from the weak Chinese housing market
- Market “violations” and “malicious short selling,” which the Chinese government has named as an important cause, while punishing nearly 200 people accused of the latter, according to The Wall Street Journal
- China’s decision to devalue the yuan by about 3 percent in mid-August
- The ending of quantitative easing in the U.S.
- The slow pace of structural reforms and restructuring of China’s state sector
- Excessive, unregulated leverage among Chinese investors, exacerbating the boom and bust
Perhaps most prevalent, Yang noted the role the Chinese government might have played in driving the market boom through June. After several years of poor stock performance, the official Chinese media turned bullish on the equity market in summer 2014, pushing a narrative that “strong stocks should reflect a strong China.” With much fanfare, the Shanghai Composite Index more than doubled by June 2015. When the bubble popped, actions such as frequent announcements of encouraging news, the massive purchasing of shares by the so-called “National Team” of state-affiliated institutional investors, the punishment of “malicious short sellers” and other government bailout activities have not stopped the slide.
While acknowledging the difficulty of knowing the exact intentions of the Chinese government, Yang shared his hypothesis that the new generation of Chinese leaders wanted to promote a bull market, but sustaining high stock prices has proven difficult, if not impossible, given weak growth conditions and complex behaviors of stock market participants. Yang’s hypothesis about the boom and bust is supported by several observations, including:
- Chinese households have saved at extraordinarily high levels over the past two to three decades, and these savings can be channeled to finance investment through IPOs.
- A bull market could generate a wealth effect for promoting domestic consumption and facilitate restructuring of the state-owned enterprises.
- This new generation of Chinese leaders wanted to generate a virtuous cycle.
“The key question is: Can the Chinese government create a bull market and sustain it through state media and the support of the National Team?” Yang asked.
But as China makes decisions internally, the effects have been felt externally. Across the entire globe, for that matter, and certainly in U.S. markets.
Evans questioned why. If Chinese stocks are falling because of complex dynamics, the U.S. would not have much to lose. American exports to China only account for less than 1 percent of U.S. gross domestic product (GDP), he said. The International Monetary Fund predicts that a 1 percent drop in Chinese GDP would only yield a 0.11 percent negative shock to U.S. GDP.
Drilling down to what might have really caused the Dow Jones Industrial Average to fall almost 7 percent in August and then another nearly 3 percent on 1 September, Evans brought up the prospect of an American market bubble.
“In May 2015, it had been four years since a 10 percent correction in the U.S. market, which is one of the longest runs in the post-World War II period,” Evans said. “So the smart money was already ready for a correction.”
As such, Evans theorized that the Chinese market turmoil served as a “coordinating event” for institutional investors — who, unlike China, dominate the U.S. market — to collectively “head for the exits.” The size of the Chinese economy and uncertainty around the government’s economic decisions — such as devaluing the yuan — were also important factors in the reaction of world markets, Evans said, but the coordinating event theory better explains the scale of the U.S. market decline.
In an informal survey of institutional investor managers, Evans said their attitudes seem to be coalescing around a few ideas:
- Hold or decrease exposure to Chinese and emerging markets.
- Hold or increase exposure to European markets and certain specific U.S. sectors.
- Hold or increase exposure to investment alternatives.
Looking ahead in the U.S., Evans highlighted the latest Cyclically Adjusted PE Ratio metrics for large and small cap stocks, which indicate U.S. markets may still be somewhat overvalued for the long term. As for what’s next in China, Evans said many economists are pessimistic about short-term prospects, but there is not much agreement regarding the longer-term horizon.