China: Actions Speak Louder Than Bombs

Soldier Mao Zedong Poster Tiananmen Square Forbidden City Beijin

We lament writing a second China-themed update in as many weeks but as they say you have to play the hand you’re dealt. All eyes are on China’s market meltdown and how the Xi Jinping’s government is grappling with control over an increasingly free marketplace.

First a few things one needs to understand about China’s stock market. The market is heavily skewed to individual participants where the US markets have a substantially larger institutional bent. By all accounts many individual investors in China’s market have borrowed to invest, most by taking loans against the equity in their houses. Leveraging in this manner allows for both compounded gains and compounded losses. Because of the inherently larger risk involved leveraged investors are acutely more sensitive to market movements and tend to be shorter term in focus. If new information comes to market that is unfavorable there can be a mass exodus to sell rather than the more institutional approach which is to buy quality and hold. This emotional, reactionary mindset can cause China’s markets can oscillate wildly from day to day. We find this an interesting departure from China’s cultural long-term view of things.

We believe we understand why China’s market has been so volatile. Their reported rate of growth was unsustainable, as their economy transitions into a more realistic rate of long term growth asset prices have to retreat to reflect reality. What’s fascinating however is the lengths to which China’s central government is attempting to control the nearly uncontrollable. Five interest rate cuts in the past nine months and a lessening of the reserve requirements on banks are meant to be a shot in the arm for Chinese markets yet their markets are still ill. Let’s move beyond the how there are intervening and look at the why for a moment.

One interesting theory put forth by a friend and client living in Singapore is China’s big military parade this September 3rd. World leaders, both sitting and former (as is the case with Tony Blair and Gehrard Schroeder) from all over the globe are arriving in Beijing for their celebration of the 70th anniversary of Japan’s surrender marking the end of World War II. Notably Japan’s Prime Minister will not be in attendance. Some 4,000 companies within a 500 kilometer radius of Beijing have been order to shut down to ensure decent air quality for the event. We’ve seen reports that claim a staggering 84% of the weapons, missiles and various implements of destruction that will be paraded through Beijing have never been seen by the public. The purpose is clear, project strength. We have to ask how effective will it be if China’s markets are in a state of panic?

The question for us is not when China’s government will alter course from direct intervention but how soon. Is now the time to be wading back in to emerging markets equities? We don’t think so, but perhaps when the ticker tape is swept up and some normalcy returns.

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