China's Economy And Markets Are Driving Global Investor Psychology And Risk Tolerance

Recent disappointing news out of China has disrupted financial markets across the globe. It started late in the day on Aug. 10 (22:00 EDT) when China announced it was devaluing its managed foreign exchange currency rate to 6.2298 from 6.1162 Yuan to the dollar. This was followed two days later by disappointing economic reports that Chinese retail sales and industrial production growth were weaker than expected in July.

The cumulative effect of these two developments shook investor confidence in global equity and credit markets, taking the S&P 500 Index intraday to the lower end of the 2015 trading range at approximately 2,050.

Early session market weakness, however, turned out to be short-lived with the S&P 500 actually ending the day marginally higher (+1.97) at 2,086.05 on August 12. As it turns out, the aforementioned episode turned out to be a precursor to what occurred on August 21 and 24 when the S&P 500 traded as low as 1,867 in the opening hour of trading on Monday, August 24.

China economic activity appears to have declined to the lower end of the range witnessed in the past 10-plus years, and weakness in Asia is now driving a recalibration of risk premium across multiple asset classes across the globe. Investors are now correct to be concerned about the future of China's economy despite the government's time-earned reputation of carefully managing GDP growth.

These concerns are particularly disconcerting considering government efforts to transition activity away from a manufacturing-based economy and toward a service and consumption-based model, which appears to be losing traction judging by the trend in retail sales (see chart).

China Retail Sales Growth

China GDP and consumption growth trends are highly relevant to U.S. corporate profitability not only because China represents the world's second-largest economy but also because nearly half of S&P 500 Index member revenues now originate from nondomestic sources. China's woes are also important company-specific concerns for any corporation with global reach looking toward Asia to improve global scale and productivity.

Global Markets Intelligence (GMI) Research notes that although China's retail sales growth of 10.5% appears quite respectable at face value, judging by the degree of weakness in auto sales that have dropped into negative territory in June and July, the risks for the broader economy at the moment appear to be to the downside.

Stock market bulls will want to see a readily apparent rebound in auto and retail sales over the balance of 2015 to alleviate fears that China may be disrupting global economic activity and multinational corporate profitability. Alternatively, a further slowing of China's economy could cause various domino effects and bring additional downside pressure to the following:

  • Commodity prices,
  • Global central bank efforts to reflate the global economy,
  • Energy, industrial, and materials sector corporate earnings, and
  • Speculative-grade bond market yield spreads.

Current financial market narrative and price action, for the moment, appear to be controlled by developments in Asia. We are following this situation closely to see if China's economy will rebound strongly from the low end of recently observed activity or if China's economy continues to slowly slip toward recession despite government efforts, which now include currency depreciation, to the contrary.    

For more detail into these observations as well as an update on our broader view of the market, please read our full Lookout Report here.  

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