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The year has begun with a major selloff in the Chinese stock market. After ten months of consecutive contraction in the Chinese manufacturing sector, concerns are increasing over capital outflows from China, where growth is at its lowest point in 25 years. Readers of this newsletter have heard the author’s skepticism repeatedly over official Chinese economic growth statistics for several years now.
The Chinese Central Bank responded to the 7% selloff through intervention, buying shares in its own stock market. On Thursday January 7, the Chinese market sold off another 7%, shutting down after only 29 minutes of trading. This would not be the first time that Chinese monetary authorities have bought their own stock market. Much criticism over this practice has lead market participants to believe that there is a disingenuous quality to the Chinese share market. “Markets” are about price discovery, not price administration, and if a market isn’t free, it’s not really a market. In August of 2015, there was another major selloff in China of 40% from its highs which impacted world stock markets and even postponed Janet Yellen from raising U.S. interest rates at the Federal Reserve. China devalued its currency then, and it should surprise no one to see it devalued much further. The “labor arbitrage” which made China such an attractive destination for global manufacturers is disappearing, while the Chinese banking system has expanded by 400% over the last seven years. A financial crisis in China, or at least a cycle of non-performing bank loans similar to what the U.S. experienced in 2008, should not be excluded by investors over the next 12-18 months. In its efforts to “purify” its markets, the Chinese Communist government has jailed many financial reporters and financial executives in 2015. China is one of the top-three jailers of journalists worldwide, and has required, since 2014, that all journalists attend mandatory training on “Marxist Views of Journalism” in order to renew their press passes. It is important that investors take note of this lack of transparency because the Chinese stock market is beginning to impact markets globally.
While the Chinese government has revised its 2016 GDP growth outlook to 6.8%, the majority of global investors see it at a rate of 5%, and I believe that the figure is far lower than that. For evidence of this, investors need only observe the price of raw materials like copper, iron ore, and steel, which are all down some 60-75% from their highs a few years ago. Chinese electricity consumption was up only 0.7% on the year, a statistic which should in principle track GDP growth closely
In the past, investors in the West shrugged off bad news concerning the second largest economy. Now the consequences are global, as we saw during the January 4th selloff. Unfortunately, even after this rout, Chinese stocks are still expensive by a factor of three, as demonstrated in the below left chart from Bloomberg:

This chart tells us that the median P/E ratio of Chinese stocks is three times higher than that of the other major world stock markets.
On the right, we have another chart outlining the unusual divergence between stock prices and commodity prices.
The latter reflects a global recession, particularly in China. The former reflects a bubble in U.S. financial assets. When will they begin to converge?
The U.S. stock market rally seen over the past six years was driven by liquidity created by the Fed. That liquidity has now stopped, and with the Fed raising rates, liquidity is now being drained from the system. Furthermore, there are other disturbing trends which suggest extreme caution for stock investors:

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  The high yield bond market is pricing in a U.S. recession. There is currently over $1 trillion of “stressed” credit.

  
  


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  Corporate debt defaults have risen to the highest level that we have seen since the last recession, while corporate debt has roughly doubled since just before the last crisis.

  
  


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  Inventories are climbing dramatically relative to sales.

  
  


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  U.S. manufacturing indices are pricing in a recession in the U.S.

  
  


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  Corporate profits are at an all-time high due to financial engineering (stock buybacks), which will now begin to decline due to higher interest rates. Expect fading EPS momentum as a result.

  
  


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  The Business Roundtable’s forecast for business investment in 2016 has dropped to the lowest level that we have seen since the last recession.

  
  


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  The velocity of money in the United States has dropped to the lowest level ever recorded.

  
  


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  Year-on-year world trade growth is nearing zero. After almost four years of falling export prices and major policy stimulus, export price deflation is almost at a point that compares to the financial crisis of 2008.

  
  


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  - Most importantly of all, U.S. stocks are still expensive. Using Nobel Laureate Robert Shiller’s CAPE index, which divides the price of a stock over its average earning over a ten year period, the S&P 500 is at 25.9 today, vs its long term historical average at 16.6.

  
  

Interest rates were raised by the Federal Reserve on December 16th for the first time in seven years. It was suggested by the Fed that there would be several more rate hikes this year. However, it is not likely that interest rates will “normalize” at any time in the near future, due to the debt led deflationary bust that is emanating from China. Excess liquidity worldwide caused by central bank money creation has led to overcapacity and factory buildup, which is putting pressure on prices. With debt worldwide at historic high levels, deflation is a dangerous thing because debt will grow as a percentage of wages. Credit contraction in China, and the banking problems that will ensue as non-performing loans begin to burgeon there, will cause further devaluations of the Yuan and a slower growth rate for all countries. It would not be surprising to see only one more rate hike in mid-year, and then either a stabilization or even a reversal in policy.

Having said that, there will be some historic opportunities in the energy sector this year. The world consumes 96 million barrels of oil per day, and there is a glut of only 6-700,000 barrels per day. The United States is the “swing” producer of oil. As U.S. oil producers fall upon hard times and go bankrupt, it is easy to forecast a drop in U.S. oil production of 1 million barrels per day. At that point, the oil glut will “swing” into a deficit and prices will begin to rise quickly. The energy sector has been very badly beaten down and will represent a great opportunity at some point in the next 3-6 months, or perhaps sooner.

The European Central Bank has only completed €540 billion of its planned €1.5 trillion of quantitative easing. The wisdom of adding to Europe’s debt can be argued, but Q.E. does make financial assets rise, as it did in the U.S. and Japan. With a falling Euro, shares of European exporters should outperform U.S. stocks, particularly if they can be currency hedged. European share valuations are much cheaper than those in the US; consider that the cyclically adjusted P/E (CAPE) ratio of the S&P 500 is at 25.9, while the CAPE index of the MSCI Europe index is only 15.8. Interest rates are still being cut in Europe, where deposit rates are now at negative 0.3%.
For the year 2015, the S&P 500 index was down 0.7%, the Dow was down 2.23%, and the Nasdaq was up 5.7%.

Grant Rogers

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