What is going on in China? Should we be worried? We keep getting asked these two questions this week.
Here is our simple, straightforward analysis of the current situation in China. The recent volatility is more of a manifestation of the jittery and nervous sentiment of investors, both retail and institutional, as well as the inexperience of China's SEC.
The lower manufacturing index is only a trigger of this week's sell-off.
China's manufacturing has been slowing for a while. China is going through a period when some bubbles are deflating, e.g. over-capacity and an over-heated real estate market, caused by excess liquidity. Increasing labor costs are challenging the old low-value added manufacturing model and a long, inevitably painful adjustment is happening. None of this is new but the unknowns of the degree and length of the adjustment is challenging investors.
China's recent decision to peg the RMB to a basket of currencies instead of the dollar is nothing new either. China has wanted to make this shift for an extensive period of time. Now that the Chinese have made the shift, the speed of the corresponding devaluation of the RMB to the dollar and ultimately the exchange rate are big unknowns and adding to investor uncertainty and apprehension.
China's adding of stock market circuit breakers at the end of 2015 has proven to be a failure and only added to the volatility, turmoil and uncertainty in their equity markets. Anticipating possible sell-offs and a free fall of the stock market after the scheduled Jan 8th lifting of the ban on major share holders in public companies from selling, China's regulators decided to implement circuit breakers to prevent the possibility of a sudden, large market slide and panic selling. To no avail, China's SEC was warned by its exchanges that the type and levels of circuit breakers would likely fail.
On Jan 4th of 2016 China's stock markets headed lower in response to the release of the disappointing manufacturing index number. The circuit breakers were triggered when the CSI300 benchmark dropped 5% and then again at a 7% drop, when trading was halted for the day. This scenario occurred again on Jan 7th. The new mechanism made investors nervous about their ability to sell and triggered even more selling. Accepting the reality of the failure of the circuit breakers to perform as intended, the Chinese SEC temporarily suspended use of them. Alternatively, the Chinese government will likely intervene via direct stock purchases to stem market declines.
Once again the market has shown the Chinese SEC that their desire to control or manipulate equity prices is futile. Underlying fundamentals, technicals and psychology ultimately determine market prices, not regulators. Equity markets will soon, perhaps this week, recover from this latest attempt by the government to control or manipulate market levels and will once again reflect investors perceptions of value.