China: The Feedback Loop Of A Bull Market

The tug of war between growth and policy reflation will remain the dominant theme this year, in which weak growth numbers will force policymakers into more aggressive reflation efforts. This is already turning out to be good news for stock prices. Indeed, even though the equity market in China is far less important than in developed countries, rising stock prices will still offer important benefits for the economy.

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Rising stock prices increase household wealth and boost confidence, which in turn supports consumer demand. This could be true everywhere, but may have just started to become relevant for China, given the rapid increase in investors’ participation in the equity market in recent years. The numbers of investor accounts in the Shanghai Stock Exchange recently hit 125 million, almost triple the level in 2007 during the previous equity mania. This amounts to over 16% of the urban population, compared with a mere 6% eight years ago. Meanwhile, there has been explosive growth in investment funds in recent years, which has also increased households’ exposure to the equity markets.

The chart above shows that consumer confidence has surged to its highest level in recent years, a highly unusual development considering the weak growth environment. We suspect this has to do with the sharp rally in stock prices and growing participation in stock equity investment. Rising consumer confidence will eventually benefit retail sales.

From policymakers’ perspective, however, a much more important consideration is the funding mechanism of the stock market.

Dollar Strength, EM Stresses = Ongoing U.S. Equity Risk

Today, a discussion about to what extent dollar strength, that leads to EM stresses, will infect U.S. bourses.

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Our EM team has been warning for some time that sharply higher foreign-currency debt levels among emerging market (EM) companies and banks will pose a formidable challenge to EM. Indeed, we have written about the risks associated with the end of the “dollar carry trade” (i.e. EM companies’ and banks’ borrowing in U.S. dollars).

With the dollar still rising, concerns about the impact of EM weakness on the U.S. and other developed markets are mounting. Could EM vulnerability to a rising dollar trigger a global financial accident? “Crises” are inherently difficult to time – it is impossible to know when investor behavior/psychology will turn. There are two points that make us leery about EM risks as they relate to U.S. (and other developed markets). First, EM is far more important in terms of its global GDP weighting than in previous decades, implying that when EM catches a cold, the rest of the world will more than just sneeze. Second, with policy options in developed economies nearly exhausted, the tool to deals with a crisis are more limited than, for example the 1990s.

At a minimum, slower demand from emerging markets and dollar strength risk creating earnings disappointments for globally-exposed sectors in developed market bourses. Indeed, the rise in the dollar and poor EM demand have been key reasons why we have advocated a domestic vs. global approach within the U.S. stock universe. A cautious approach is still warranted.