The downfall in the Chinese stock market is particularly difficult in a country where many recent investors are new to the stock market and until recently have mostly seen a rising market. As the Chinese stock market rocketed higher in 2014 and early 2015 it lured tens of millions of new investors into the stock market. Those market gains led the Chinese stock market to become the second largest in the world, at more than ten trillion dollars, after that of the U.S. According to China Securities Depository and Clearing, by early 2015, there were more than 90 million individual investors in China. Forty million of those investors started trading within just the previous 12 months.
Unfortunately, until the market collapse, many of those new investors were without understanding of the risks of investing. The Chinese market plunge of the last nine months, coupled with an already weak Chinese economy, has further weakened confidence to investors, businesses and consumers in China. It has also erased the mirage of artificial wealth that had been built up by easy credit and the previously booming stock market. Efforts from Chinese government officials to artificially boost their stock market have mostly failed, leading to even further losses of confidence for Chinese and world investors.
The direction of the Chinese stock market and its economy has direct implications for investors around the world. The downturn in the Chinese market has already affected global stock markets and their economies too, as Chinese consumers and businesses alter buying patterns in response to losses of stock market wealth. Despite Fed officials’ show of unconcern of the Chinese economy and its markets, the size of the Chinese economy is now too big to ignore.
According to the World Bank and the IMF, on the basis of purchasing power parity, the Chinese economy is now the largest in the world, surpassing the U.S. within the last few years. Using this measure of economic activity, over the last 30 years, the size of the U.S. economy has nearly quadrupled. However, during the same span, the Chinese economy has grown by an incredible 30 times, to the point where it now represents about 17% of the economic activity of the globe. And with China and the U.S. now combining to contribute a third of the world’s economic activity, the economies of China and the U.S. are crucial for the health of the world’s population. It is the threat of bursting bubbles in these two countries that is leading to increasing market and economic difficulties in much of the world.
What has precipitated the bubbles in the U.S. and China is of course, debt. In the U.S., total debt doubled from the beginning of 2000 to the eve of the financial crisis at the beginning of 2008 (see chart below). From the start of the financial crisis, consumers, governments and businesses where only able to reduce total debts by about 2% before the Fed’s 0% interest rates nearly forced them to resume the program of debt accumulation.
A side consequence of easy credit has been the formulation and furthering of financial bubbles, notably those in stock, bond, and housing markets, inside and out of the U.S. and China.
In the U.S., bubble areas in the stock market over the past couple years have especially been seen in technology companies, such as the highflying “FANG” stocks of Facebook, Amazon, Netflix, and Google. Those stocks and many other technology, biotechnology and internet companies have been bid up to nose-bleed levels, often trading at hundreds of times earnings (if they have earnings) and more than ten times yearly revenues. Since the lows in early 2009, the Dow Jones Internet Index increased by more than 600% by the end of 2015. After laying dormant for nearly a decade, part two of the dot-com bubble has resurfaced. But instead of the 1990s “horsemen” such as Microsoft, Cisco Systems and Broadcom, today we have Amazon, Facebook and Netflix. Same story, different actors.
While some of the steam of internet stocks has been released over the last couple months (down more than 25% since late 2015), a true crash will see many of these stocks fall by more than 80% or 90%, as happened in the 2000-2002 dot.com bubble bust. If the current tech bubble fully bursts, the spillover to the broader stock market will be inevitable, as was the case in the last two bursting bubbles. When bubbles completely rupture, it’s not just the froth that gets taken out, but the entire stock market undergoes a structural repricing.
In the U.S. market, it’s not just technology stocks that are currently overvalued. By measures such as Tobin Q, Median price-earnings multiple and the Schiller PE ratio - all of which have reliably spotlighted stock overvaluation and associated future underperformance – the U.S. stock market as a whole is at historically very high levels, not seen apart from major stock market bubbles – and subsequent crashes – like those in 1929, 1969, 1999 and 2008. In a recent article I noted that even after the declines in U.S. stocks this year, by the measure of the Schiller PE ratio, the U.S. market is still about 50% higher overall than its historic average.
The Chinese stock market is even more overvalued than the U.S. market, with the total market valuation more than 100 times the earnings of the underlying companies. The overvaluation in China’s technology stock sector has been compared to the 1990s dot-com bubble in the U.S. In just the first three months of 2015, just before the beginning of the Chinese market collapse, China’s CSI 300 Technology index climbed an incredible 69%. Over the prior 12 months, of the top 50 returning global technology companies with market valuations above $1 billion, all 50 were from China.
Across the world, bond markets are also in bubble territory. Businesses borrowing at under 1% interest rates and governments borrowing at negative interest rates are clear evidence of market distortions and overvaluation. The Federal Reserve in the U.S. and other foreign central banks have promised to backstop the bond market generally and interest rates specifically. Businesses and governments are borrowing at record low interest rates because they can and to maximize earnings, even if it increases longer-term risk. Individuals are buying low interest rate bonds because they see a lack of alternative investments that they perceive is as safe. Locking up money for ten years at 2% or six months at 0.25% doesn’t seem to make sense, except in a world when there aren’t moderate-return, low-risk investments any more. In their absence, investors push for perceived safety and any available yield, bidding up prices still more and further growing the bubble.
While areas of the U.S., Canada and Europe show signs of real estate bubbles, the mother of property bubbles is currently in China. Amid the fallout of the worldwide financial downturn of 2008, the Chinese government launched a capital spending program, spending more $600 billion on Chinese infrastructure projects like railroads, airports and roads, as well as housing development and rehabilitation. While the result of such development certainly led to higher economic growth in China, they did so at the expense of the debt needed to carry out the projects and higher risks down the road. Since the entire $4 trillion yuan building programs would be borrowed by Chinese central, provincial and local governments, those debts would sit on government balance sheets, weakening the financial position of China and adding to borrowing costs. In addition, sharp increases in debt by corporations in the years since 2008 has further leveraged China’s economy, to the point where it is no longer a country with low debt levels.
A 2014 study by global think-tank Carnegie Endowment for International Peace concluded that China’s debt problems were “rooted” in the government’s $4 trillion economic “stimulus” plan. That report was written at least 18 months ago. Since then, debt and leverage ratios have only increased while a stock market crash and weakness in housing prices has further weakened China’s economic conditions.
By 2014, China’s total debt (Corporate, Household and Government) reached $28 trillion, and over 230% of Gross Domestic Product, nearly equal to the levels of England, France and the U.S., and more leveraged than the economies of Germany, Brazil or Russia. Corporate debt is particularly high in China, increasing sharply in the wake of industrial spending programs, and perhaps most vulnerable now to the sharp decline in the Chinese stock market and the financial stresses now surging through China.
There is no doubt that economic demand in China is falling. China has been by far the biggest consumer of many commodities for the past decade and with the downturn of construction in China, the prices of many commodities, including oil, has collapsed. (see chart below). This in turn, has had severely negative ramifications for global commodity and energy companies, as well as entire countries, such as Canada, Brazil, Russia, Colombia and Australia, whose revenues are dependent on the exports of commodity and energy products.
The rapidly falling global demand for goods is also seen in the stunning collapse of the Baltic Dry Index, an index reflecting global shipping demand, down an incredible 80% since peaking in late 2013.
It is only due to the extremely easy credit conditions that more countries and companies are not suffering more than they already have. But while governments may attempt to keep interest rates wrestled to the floor, weaker economic conditions have already led investors of many riskier bonds to push yields higher. Barclay’s index of high-yield (“junk”) bonds has already declined by more than 15% since mid-2015, pushing up borrowing costs and making it more difficult for debt-burdened companies to ride out this period of low commodity prices.
This week it was announced that 67 U.S. energy companies declared bankruptcy in 2015, up from 15 and 14, respectively, in the two previous years. With even lower oil prices in store for 2016, it is likely that this year will see even more bankruptcy filings this year. An oil & gas analyst from Oppenheimer recently gave the opinion that half of U.S. shale oil producers could go bankrupt before oil prices “normalize” at higher levels. Unfortunately, such fallout may be only the tip of the iceberg if worldwide demand remains dormant for any significant period of time.
When bubbles collapse, asset prices do too. But those debts acquired during the easy times don’t go down, which is what exposes the bubbles for what they were. If I have a $400,000 mortgage on a house the market thinks is worth $500,000, then it’s not a big problem. But if the market changes its mind and now thinks the house is only worth $200,000, then I have a problem, and if I have any sort of difficulty with my income, my cash flow, my banker and I both have a big problem.
Falling asset, or equity, prices expose underlying debts, which is why governments and Fed officials work so feverishly to prevent falling asset prices, or at least to regenerate new bubbles. However, even if bursting bubbles are replaced with new ones – we have now had multiple cycles of this in the U.S. in the last 15 years alone – they will cause dislocations and reallocations, and pain for many.
That is where we are now, but the difference between now and the bursting of past bubbles is that it is not just the U.S. that is the contributor to monetary mayhem. China and the U.S. together (not to mention other very indebted countries) are so large and influential on the world stage that the difficult and distressing reorganization of the economies of these two countries will perhaps be the most challenging bubble clean-up ever seen.