by Roy C. Smith
China’s market crash began in June, but has accelerated rapidly since, despite massive intervention by government entities to stop it.
These global market corrections have developed a tendency to be sudden and steep when they kick in.
However, they are always in response to three fundamental factors.
First – digesting the new news. China’s economic slowdown is not new news at all. Nor is its effect on global commodity prices, including oil. Clearly, a slowdown to probably less than 7% annual growth from 12% five years ago was going to affect other markets and investors have had plenty of time to make adjustments.
China’s intervention to attempt to stimulate growth in 2014 is not new either – China was expected to use its vast power in the economic realm to improve things, despite a commitment of some sort to allowing market forces to have more influence.
One consequence of the stimulative effort, however, was the enormous bubble in Chinese stocks that began about a year ago. The bubble has now burst; with all the usual effects, but, even so, the Shanghai Composite is only back to about where it was when the bubble began.
What is new is the fact that even after $200 billion of government-mandated purchases of equities, the Chinese market continued to drop sharply. This has forced China’s massive intervention to switch back to lowering interest rates and easing money, a move that may not work either but certainly will increase risk in the already bloated credit sector. China has serious political and economic issues ahead, but not all of these have global consequences.
Second – psychological forces are released. These are several. A major one may be that investors may no longer consider China to be an invincible economic superpower; instead conventional wisdom may have changed to regarding China as (only) a large but troubled emerging market economy with lots of growing problems.
But a global markets move of this magnitude – this is the fourth time that the VIX (US volatility index) has exceeded 40% since 2008; most of the time it has remained below 20% – unleashes investor responses typical of behavioural economics (and originally described by Keynes in the 1920s). It’s not what the investors think about all this that matters, its what they think other investors will do. If there is likely to be a sell off, these investors will want to act first to get in ahead of it. This means that corrections, when they come, are accelerated, at least until the expectation of what others will do changes.
Third – the underpinnings of the technology driven marketplace are not what you think. There are now a multitude of so-called exchanges on which stocks can be traded electronically. The NYSE and Nasdaq today only account for 25% of trading in US equities – so when a sell off occurs there is a frantic search for liquidity. Banks and broker dealers are also less active as market-makers than they were due to regulatory changes.
But it is more than liquidity. Around 30% of all equity trades today are in passive indices or ETFs, which have to be rebased when markets move rapidly. This is more difficult to do when circuit breakers designed to lower volatility are triggered. In turn this complicates pricing in the equity derivatives markets, leaving all of it in a twisted mess of mispricing until things get back to normal. So the prices you see in the midst of a crisis may be illusory.
But illusions can result in bad judgements. In 2008 a long but slow adjustment was already taking place in the overleveraged mortgage finance sector. These adjustments endangered a number of firms with heavy exposures, but there was no real avalanche until September when the US government wrong-footed markets by allowing Lehman to fail, AIG to live and embarked on several months of unpredictable interventions in markets to save the banks and automakers. This resulted in a rapid acceleration of psychological factors that panicked markets and led to a sharp fall off in GDP growth, which then became new news to which markets further had to adjust.
Most investors survive global market sell-offs with cool heads. They reflect on what is really new, and how much of the adjustment is driven by psychological factors and stresses in market pricing. Governments, however, may be more inclined to jump in and do something, even though increasingly evidence is developing that market intervention can make things worse, sometimes much worse.
China has intervened in this episode in massive ways, spending vast amounts in efforts to stabilise both the stock market and the yuan, without lasting success. It has also intervened in lending markets to extend a credit bubble within China that had already pushed total debt to 250% of GDP.
China has acted as if it has unlimited confidence in its ability to override market forces, despite evidence that this is not the case. It needs a cooler head to intervene less and let market forces restore equilibrium. So far, there is little sign that this will happen, but China may be learning more from experience than we know.