Stock markets started the New Year off with a bang, but not a good one, as panic in Chinese markets spread throughout the globe.
We last wrote about China in July when their markets dipped 40% after doubling in the prior 12 months. Some of what we are seeing in China today is related to the restrictions and regulations Chinese officials put in place last summer to “control” the price declines. The article linked above describes in more detail why these measures were likely to prove ineffective, and that has played out so far in 2016.
Some of China’s stock market drop last week could be attributed to unwinding of restrictions on investors with a greater than 5% stake selling their shares – pent up demand from sellers that have been forced to hold positions for about six months was expected to put some downward pressure on prices. After last week’s turmoil though, Chinese officials might make the restrictions permanent instead of unwinding them.
In addition, new circuit breaker rules (halt trading for 15 minutes after a 5% decline and close trading after a 7% decline) went into effect on January 4 and seemed to add to the panic. Trading shut down on January 4 following a 7% loss, and the circuit breakers went into effect again just three days later when China’s market declined 7% in just 29 minutes. Even though most markets have circuit breakers to prevent irrational selling, China’s trading limits are probably too tight. For comparison, U.S. markets only shut down after a 20% decline.
Like we said last summer, markets don’t respond well to measures designed to control the flows of capital. Poorly designed circuit breakers, uncertainty regarding restrictive regulatory policy, and the fresh memories of many Chinese companies not trading for several months is fueling more panic than Chinese officials intended.
Also contributing to the negative sentiment in China is weakening economic data and the declining yuan. China’s economic slowdown is a widely anticipated feature of their economic transition from a manufacturing-led economy to one driven by consumer-spending. Similarly, the yuan was widely expected to decline when China removed its loose peg to the U.S. Dollar last August. However, the magnitude of the yuan’s decline has been surprising and some people believe it signals that China’s economy is worse off than most people believe.
So why are other global stock markets falling?
Emerging market countries, particularly those that are commodity-driven and rely on Chinese demand, are particularly susceptible to China’s woes. Developed economies ought to be more insulated from a slowdown in China, but the devaluation of the yuan does have major implications for global deflationary forces.
For U.S. investors, we shouldn’t ignore the simple fact that U.S. markets are trading at valuation levels that make them more sensitive to negative news than positive news. We’ve repeated frequently throughout the past year that current valuations suggest that stock prices are vulnerable to unexpected shocks and long-term returns have an increased probability of trailing historical average returns.
We still expect market exposure to continue delivering higher long-term returns than fixed income, alternatives, or cash. In order to receive a rational premium for owning stocks, they occasionally need to lose value. Stay invested during the down markets and time will reward you for your patience.
Sources and Disclosures:
PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS. Investing involves risk. It should not be assumed that recommendations made in the future will be profitable or will equal the performance shown. Investment returns and principal value of an investment will fluctuate and losses may occur. Diversification does not ensure a profit or guarantee against a loss.
