China Sneezes

It is often said with regard to the global economy that when America sneezes, the rest of the world catches a cold. The validity of that aphorism has been proven many times over, as nearly every major stock market correction in the United States over the past thirty years has been followed by an economic slowdown in other developed nations. But is the opposite also true?

It looks like we’re about to find out, as the Chinese stock market has crashed hard over the past six weeks. Since peaking at 5166 on June 12th, the Shanghai Composite Index quickly dropped below the 3700 level, a decline of nearly 30% in just six weeks! Most notably, in one day (July 27th), the index plunged more than 8%, leading to speculation that an all-out rout was in full swing.

It remains to be seen how much longer this breathtaking descent will continue, but even if it’s over it is still cause for concern. A recent report on CNBC noted that this sudden reversal-of-fortune for the Chinese stock market might have profound implications for U.S. companies that generate significant revenue from China and its Asian neighbors.

Specifically mentioned were two Personal Finance Growth Portfolio holdings: mobility chip manufacturer Qualcomm (NASDAQ: QCOM), and oilfield servicer Schlumberger (NYSE: SLB). In fact, both Qualcomm and Schlumberger did see their share prices drop in the days following China’s historic plunge, suggesting investors may well indeed perceive it as a threat to both company’s future earnings potential.

We won’t know for some time the extent of any cause-and-effect relationship between China’s stock market and the impact that will have on American companies doing business over there. My guess is the basic necessities both these companies derive their revenue from over there (smartphones and gasoline) enjoy fairly inelastic demand, and will not suffer to the same degree as big ticket discretionary items such as automobiles.

That suspicion was echoed by U.S. auto manufacturer and current PF Income Portfolio holding Ford Motor Co. (NYSE: F) when it announced its quarterly sales results on July 28th. The company described future sales growth in China as “a concern”, and reduced its estimated vehicle sales for the remainder of the year by as much as 2.5 million units, a decrease of 10%.

Perhaps more so than any other developed nation, China abides by a “boom or bust” type of mentality with respect to its financial markets. Certainly the United States has been guilty of encouraging overheating of its stock and real estate markets periodically by manipulating interest rates and providing tax incentives, but at least there is an attempt to maintain a clear line of demarcation between public policy and private investment.

Not so with China. True to its collective mindset, often times the degree of public/private cooperation is not fully known until well after the fact. That also makes its stock market difficult to regulate since some practices that are prohibited in other parts of the world are not disallowed in China, or are at least conveniently overlooked.

As a result, many institutional investors refuse to directly own shares of Chinese companies, and instead elect to invest in non-Chinese companies that trade on more tightly regulated exchanges (such as U.S.-based Qualcomm, or Paris-headquartered Schlumberger) as a way to indirectly participate in the growth of the Chinese economy.

Somewhat comically, in the aftermath of the Chinese stock market meltdown its government threatened to fully prosecute illegal short sellers, as if to (unintentionally) imply that is not always the case. Other activities that tend to amplify volatility in the stock market such as day-trading are not only legal, but viewed as a perfectly ordinary way to acquire wealth. The combined effect of all of these elements is a stock market that tends to careen from one extreme to the other, gaining momentum in either direction as investors jump on and off the bandwagon with regularity.

That being the case, unlike the U.S. stock market, which is generally regarded as a leading indicator of economic prosperity, the Chinese stock market behaves more like a mirror, reflecting the prevailing mood of investor sentiment. Until recently that sentiment was decidedly bullish, based primarily on the belief that there simply is no stopping the Chinese economy given the size of its population and rapid ascension to the second largest economy in the world.

But it is no secret, and should come as no surprise, that the Chinese economy is slowing down as it matures. However, the rate at which it is slowing, and the full impact that is having on several of its industries, is a bit more difficult to ascertain in China than it is in most other developed nations due to government obfuscation of its true condition.

For all those reasons, it is unlikely that the mere occasion of a substantial decline in the Chinese stock market will necessarily result in a similar drop in global stock markets. The fact of the matter is that even after its 30% plunge, the Shanghai Composite Index was still up 15% so far this year, far greater than the 2% return of the S&P 500 Index over the same period.

In the near term there most likely will be repercussions for companies that derive most of their income from China’s economy, as well as collateral damage to vendors and suppliers of those businesses. But most American companies should suffer only minor financial damage, if any at all, and many have controls in place to quickly stop the bleeding if China’s stock market continues to plummet.

Regardless, that is one more reason why we restrict the Personal Finance Growth portfolio to only S&P 500 index companies. The inherent risks of the stock market are more than enough to challenge most investors, so there is no good reason to add to them an unquantifiable amount of risk that the sometimes undecipherable and oftentimes temperamental Chinese stock market presents.