The Overnight Report: The China Syndrome

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By Greg Peel

The Dow fell 186 points or 2.0% while the S&P dropped 2.4% to 979 and the Nasdaq dropped 2.8%.

While the rest of the world was enjoying a second leg of the rally in August, fuelled by improving global economic data and a positive US earnings season, China has been correcting. From November low to July peak the Shanghai market had rallied over 90% and since that peak it has now fallen around 14%. Yesterday the index posted its biggest single drop since November in falling 5.8%, setting off a wave of selling in Asia and Australia which rolled around the globe into Europe and finally the US.

The extraordinary rally in Chinese shares was fuelled by China’s massive (on a comparative GDP ratio basis) stimulus package which includes both direct fiscal stimulus with an infrastructure bent and easy monetary policy in which banks have been effectively “ordered” to lend for the purpose of stimulating China’s domestic economy. While this lending is intended to drive construction and consumer spending, it has also had the effect of creating an asset price bubble as gambling-mad Chinese have once again flooded into the stock market. Property prices have seen similar effects.

The market peaked when rumours began to circulate that the Chinese authorities were considering reining in easy monetary policy via an interest rate rise in order to prevent a bubble becoming yet another bust. Economists tend to believe China will maintain its easy policy at least until developed economies begin to recover and buy Chinese exports again, but despite no official word from China on a policy adjustment the rumours continue. China has also become spooked by a new rash of large IPOs which is flooding a lofty market with new shares. Throw in fears that the extraordinary Chinese commodity buying of the first half of 2009 was reaching finality and you have the recipe for a good pull-back.

That pull-back accelerated last night with a 5.8% drop, and around the globe it was a case of looking at one’s own market and as to whether the latest rally, in which China has also been a fundamental driving force via its apparent rapid return to GDP growth, is overdone in the short term.

Two 10% individual stock price falls on either side of the globe are good examples of just why many believe stock markets have run ahead of themselves.

The global copper price has run up around 110% since November on the back of Chinese buying but yesterday Yunnan Copper – China’s third biggest copper producer -announced a surprising first-half loss based what it noted was a lack of demand for the metal. This brings the “stockpiling only” argument clearly into focus.

In the US, retailing giant Lowe’s posted a 19% fall in second quarter profit last night on the back of revenues well short of Wall Street expectations. To make matters worse, Lowe’s offered a third quarter guidance range in which the top end was below analyst forecasts. Still reeling from Friday’s big drop in the US consumer confidence measure, Wall Street was again reminded that there can be no rapid return to economic growth without the US consumer.

China knows this too, given a large proportion of its once 60% of GDP export economy had US consumers on the other side.

The result was that an already nervous Wall Street made one big adjustment last night. All three indices opened down at what was to be pretty much their lows for the day. The rest of the session’s trading was a flat line.

Lost in the wash last night was news that the US housing sentiment index added another point in August to reach 18 – its highest level since June last year – following two big jumps in previous months. The sentiment measurement was weighted towards prospective sales rather than current sales nevertheless, which leads analysts to suggest a late rush is building ahead of the expiry of the government housing grant (tax credit) which expires in November.

There was also good news over the weekend for listed healthcare stocks as the Obama Administration made the first indications it might water down the public element of its proposed universal healthcare scheme.

Most striking, however, was the Empire State (New York) manufacturing index reading. Economists were expecting a jump from the negative to about a positive 3 point read, but instead the index leapt an astonishing 13 points to 12.1. That’s its best reading since November 2007. More sceptical analysts nevertheless noted that improvements in the sentiment part of the measure far outweighed actual manufacturing activity results.

It was Wall Street’s worst one day performance since the beginning of July when last the market began to think a pull-back might be on the cards. Stock market weakness prompted a rush back into the US dollar, which jumped 0.7% on the index to 79.31. The index move was nevertheless tempered by a rush to buy back yen and reverse carry trade positions. US Treasury bonds also saw strong buying, sending the ten-year yield down 9 basis points to 3.47%.

A strong US dollar and strong yen are a double-whammy for the Aussie which lost over a cent from Friday to US$0.8211.

One might have expected a big drop in stocks would be reason to buy gold, but gold is no longer trading as a hedge against financial Armageddon. It is currently under the influence of expectation of ongoing secular weakness in the US dollar, and thus last night’s dollar surge sent gold tumbling US$13.70 to US$932.90/oz.

All things considered, base metals should have taken a big tumble last night but given they had already begun to lose their bottle in Friday’s session, falls were not too steep. Copper, lead, nickel and zinc fell 1-2% while tin fell 4% but aluminium edged slightly higher.

Weakness in Asia was also compounded yesterday by the release of Japan’s second quarter GDP, which at 0.9% growth fell short of the 1.0% expected. This may have been an immediate set-back, but in a global context 0.9% growth in Japan on the back of 0.3% results for both Germany and France shows that the other big developed world economies are turning around faster than the US. This is positive news given many previously worried that even if the US was able to post a stimulus-led recovery, Japan and Europe would struggle.

The SPI Overnight fell 45 points or 1%, taking into consideration Australia had already responded to China’s big drop yesterday in falling 1.6%.

In the meantime, Australia’s reporting season continues to rev up. The FNArena calendar notes 14 profit releases today which include Rio Tinto ((RIO)), James Hardie ((JHX)), OneSteel ((OST)) and United Group ((UGL)).

For the full list of reporting dates and major economic data releases please refer to the FNArena calendar.

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