What happens in China MATTERS! (Economy/Fidelity)

What a China selloff may mean for U.S. investors

It’s not just about the market rout. It’s about a structural shift to slower growth.

• BY DIRK HOFSCHIRE, CFA, SVP; LISA EMSBO-MATTINGLY, DIRECTOR; IRINA TYTELL, PHD, SENIOR RESEARCH ANALYST; AND JOSHUA LUND-WILDE, RESEARCH ANALYST, ASSET ALLOCATION RESEARCH, 
• FIDELITY VIEWPOINTS 
• – 07/09/2015

• Market Analysis

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Chinese stocks have dropped sharply

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For illustration only. Performance based on the Dow Jones Shanghai Index and Dow Jones Shenzen Index. Data from April 1 to July 7. Source: FactSet.

Stocks in China's Shanghai Composite Index fell nearly 6% on Tuesday, and have dropped more than 32% since June. The selloff has contributed to volatility in bond and currency markets, and is another sign of stress in the world’s second largest and formerly fastest-growing economy.

The rally in Chinese stock prices through the first few months of 2015 had made it one of the best performing markets in the world, but the markets have entered bear market territory in the past few days. (See chart right.) In an effort to stabilize stock prices, Chinese policymakers have taken a series of measures in recent days, including instructing large brokerage companies to buy shares. Our broader concern is about how this episode sheds light on China’s policy struggles at a time of mounting economic and financial challenges.

What happens in China matters. China is in the midst of a difficult, multi-year transition to a slower-growth economy. This flattening trajectory is serving to reinforce the slow-growth, low-interest-rate global environment. We believe China’s 10% annual Gross Domestic Product (GDP) growth in recent decades has been giving way to a secular rate that should average closer to 4% over the next two decades, as demographics deteriorate and productivity growth moderates.

Complicating this transition is that it coincides with the end of a multi-year cyclical credit and real estate boom that leave China’s economy burdened by industrial overcapacity and severe financial imbalances. Private credit growth has outpaced economic growth nearly two-fold since 2009, leaving China’s private sector with much higher debt than the U.S. relative to the size of its economy.

China’s monetary expansion has led to a central bank balance sheet that is now the world’s largest and has grown more quickly than the Federal Reserve’s during the past decade.

Economies confronting similar severe credit and housing-price imbalances have faced a fundamental policy dilemma: Rein in excesses now and accept the pain of much slower near-term growth to improve medium-term prospects; or postpone the hard decisions, boost policy stimulus to maintain growth, and ultimately incur greater potential slowing over the medium term.

In our view, the most likely scenario remains the latter—that China’s policymakers are prioritizing current macro stability, which suggests potentially lower cyclical risk in the short run but a prolonged trend of weakening over the medium term.

Aggressive monetary policy easing should help

Earlier in 2015, we believe China re-entered the “growth recession” phase of the business cycle due to renewed, widespread weakness across most indicators. In recent years, export growth has waned as the primary driver of economic activity, and overbuilding in the property sector has depressed construction levels. As a result, industrial production in March sank to its lowest level in at least six years, a sign that the fixed-asset investment boom that has powered China’s growth is running out of steam.1

In response, China’s policymakers have become increasingly aggressive in their easing efforts. Larger-than-expected cuts in policy interest rates and banks’ required reserve ratios in recent months represent an acknowledgment that more limited measures were insufficient to stabilize growth. Most structural reforms to address imbalances have proceeded slowly. Chinese regulators have allowed the slow recognition of nonperforming loans and eased bank loan-to-deposit ratio rules. The government also appears to be softening its efforts to rein in the off-balance-sheet financing vehicles of local governments.

Deeper restructuring needed for early-cycle recovery

Central bank balance sheets

China’s central bank balance sheet now stands at more than $5 trillion, the largest in the world

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Source: People’s Bank of China, Federal Reserve, Haver Analytics, Fidelity Investments (AART), as of Dec. 31, 2014.

Some recent data in the property and industrial sectors point to a degree of near-term economic stabilization, and China’s stimulus measures will likely intensify in the near term to further support this trend. According to our business cycle framework, however, downside risks remain until China can jettison the excesses of the last boom and clear the obstacles to an early-cycle recovery.

Shifts in business cycle phases are typically driven by market-induced changes in inventories, credit, and corporate profits, in addition to monetary and fiscal policies. What China is missing in its current cycle are the market adjustments that correct previous excesses. China’s inventories remain high, particularly the surplus capacity in real estate and heavy industries.

Credit growth continues to slow as troubled loans are rolled over and demand for new borrowing remains muted. Profits are constrained by high wages and excess capacity, particularly in the industrial sector, where profit growth has turned negative (see chart, right). Monetary easing and new fiscal spending can boost activity, but they do not provide the recessionary adjustment that typically allows for the next economic upswing.

For China to truly reaccelerate into an early-cycle recovery, it will need more market-oriented adjustments: writing off more bad loans, reducing production in businesses plagued by overcapacity, and generally creating conditions that incentivize the reallocation of resources to more productive economic sectors. Policy stimulus may be able to stabilize short-term trends, but as long as near-term stability is prioritized over deeper restructuring, a sustainable, early-cycle reacceleration will remain elusive.

Potential risk: Devaluation pressure from capital outflows

Foreign capital outflows and bank claims

With foreign bank claims still near all-time highs, China experienced over $200B in foreign capital outflows in Q1

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Source: Bank for International Settlements, Haver Analytics, Fidelity Investments (AART), as of Mar. 31, 2015.

In the early 1990s, Japan’s policymakers similarly favored near-term stability over fast adjustment in response to the bursting of its real estate bubble, leading to several years of economic stagnancy and an eventual banking crisis in 1997. Although China’s economy is substantially different, our expectation is that it may experience something like Japan’s “slow burn” of gradually unwinding large imbalances, implying a prolonged period of decelerating growth but near-term financial stability.

However, one potential risk to this thesis is the possibility that capital outflows cause Chinese policymakers to be either unwilling or unable to continue to defend the value of its currency, the renminbi. In a reversal of prior years when foreign capital flowed into China to take advantage of higher rates and a strengthening currency, capital outflows have accelerated in recent months, leading China to spend more than $260 billion of foreign exchange reserves to maintain its pegged exchange-rate regime.2

While China still has ample reserves ($3.7 trillion) and a generally closed capital account, it also has nearly $800 billion in short-term foreign-currency bank claims. In addition, the strong currency and reserve decumulation is effectively a policy tightening that works against China’s easing measures. While it is not our projected outcome, a possible large devaluation of the Chinese currency is perhaps the biggest risk to global economic and financial stability.

China’s impact on our asset allocation outlook

In general, China’s economic growth downshift and its inability to sustainably reaccelerate provide a disinflationary force to the global backdrop. As the world’s second largest and formerly fastest-growing economy, China’s muted trajectory is serving to reinforce the slow-growth, low-interest-rate global environment.

Emerging market spillover 

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Past performance is no guarantee of future results. You cannot invest directly in an index. All indices are unmanaged. China-Related ex-China (Asia): Korea, Malaysia, Taiwan, and Thailand. Commodity Exporters: Brazil, Chile, Colombia, Indonesia, Peru, Russia, and South Africa. China equity index: see index definitions below. Source: MSCI, Haver Analytics, Fidelity Investments (AART), as of July 7, 2015.

China stocks 
In our view, China’s economic and profit outlook provided little justification for the recent massive rally in its equity markets at the beginning of 2015, but the rise was powered by strong technical factors. Government encouragement of stock investment, limited choices for domestic investors, rampant use of margin buying, and monetary easing measures (with the promise of more) have stoked the rally. There are plenty of promising individual opportunities over the long-term among Chinese companies. However, many stocks grew much less compelling from a valuation standpoint, and cyclical profit headwinds and macro risks appear persistent.

Emerging-market stocks and commodities
China’s infrastructure boom was the paramount driver of the rapid rise in commodity prices during the first decade of the 2000s, and its demand underpinned the brisk growth in commodity-producing countries, East Asian trading partners, and emerging markets generally. Chinese policymakers continue to favor infrastructure spending and projects such as railways and subways, but the ability to accelerate growth from such high aggregate levels will be limited. Demand for commodities is thus likely to continue in a generally firm but slowing trend, which adversely affects commodity producers (see chart, right). Exporters of commodities such as iron ore or coal—like Australia, with China as the major destination—will face the biggest headwinds.

The bottom line

The dramatic selloff in China in recent weeks has unsettled many investors and sent ripples through currency and bond markets. But the bigger issue may be the direction of China’s economy. We think there are reasons to believe that the country is in midst of a transition to a period of slower growth and it could contribute to a slow-growth, low-interest-rate global environments.