Look East for market direction

When the stock market of the world’s second largest economy jumps more than 450 points, or 8%, in a week, it is time to sit up and take notice. The Shanghai Composite index, which acts as the benchmark for Chinese stocks, is now at 2018 levels, and after a slow and steady rise along with global stocks since March this year, it has been on a tear higher in the past two weeks. Below we will analyse why this is happening, and what this means for global stock markets. 

 Why Chinese stocks are so hot right now 

There are a multitude of reasons why China has started to play catch up with US stock markets. It hasn’t faced a second wave of the virus in the same way that the US has, added to this its economic recovery seems to be on a more secure footing compared with the US, where the potential for future lockdowns of large swathes of the economy looks like a real possibility. In China, the Caixin non-manufacturing PMI for June beat expectations to rise to its highest level since 2014. This tells us a couple of things: firstly, that the Chinese economic recovery from Covid-19 is going to be led by the service sector, and by consumption, and secondly, that this could be a bullish signal for global stocks and other risky assets. 

Why the world needs the Chinese consumer 

The world has been crying out for a rise in Chinese consumption, none more so than US President Trump who lamented all of the imports to the US from China without reciprocation. Now could be the perfect time for US companies to level the playing field and sell to Chinese consumers who are poised to buy. Traditionally China was seen as a manufacturing economy and a heavy user of raw materials. However, the Chinese economy is on the turn. This is also exemplified by the Caixin PMI data, the manufacturing data for June showed a return to January’s level, however at 51.2, it was well below the stunning 58.4 for the service sector. If Chinese consumption does drive the Chinese economic recovery for the rest of this year then the key beneficiaries could be: South Korea, Taiwan, Japan, the US and Germany, who are the world’s largest importers to China. In May China’s balance of trade was more than $60bn, which has been pretty stable for most of the last 5 years. If this starts to shrink, led by a strong pick up in Chinese consumption, then we may see a shift in the global balance of payments with more money flowing out of China and into other parts of Asia, the US and Europe. This, in theory, should be good news for global stock markets. The FTSE 100, which has lagged its European and US peers in the market rally since March, could also be a beneficiary as the UK tries to forge stronger links with China post Brexit. Other beneficiaries include emerging markets, particularly those that could take the baton from China and become the world’s next centre of manufacturing and export-led growth. Vietnam could be a clear winner if China shifts to a less export-orientated economy. 

Who would lose from a resurgent Chinese consumer? 

There would also likely be some losers. Australia has been reliant on China for decades to buy up its raw materials to fuel its production and manufacturing engines. In time, this demand could slow, as a Chinese economy that is focused on the consumer would need fewer raw materials such as iron ore and copper etc. However, this is tomorrow’s problem. Right now, China’s stock market surge has been accompanied by a rise in industrial metals prices, which are up some 8% this week. Thus, as stocks in the West have been lacking direction, in the East and in the commodity markets bullish signals abound. 

The power of state media on financial markets  

Another key driver of the Chinese stock market this week has been calls from the government in Beijing for retail traders to get behind the stock market and start buying Chinese equities. State-run Chinese media has also promoted the buying of equities. So, while there is an overarching theme to the stock market rise, we cannot deny that there has also been some jawboning to get the vast number of Chinese retail traders to help prop up the rally. 

Banking on China’s great reflation trade 

This leads to our last point, the interest rate differential between 10-year US yields and the equivalent in Chinese yields is now at 2.4%, which is higher than the last peak reached in September 2011. China is set to have higher interest rates compared to the US and Europe for many years to come, thus, stronger inflation rates in China could help to tackle global deflation pressures that have been an economic side effect of Covid-19. For example, if China’s economy goes from strength to strength in the coming months, and if this growth is driven by the consumer, then consumer-orientated exports from the rest of the world, for example luxury cars from Germany and the UK, Apple products from the US, and designer handbags from Europe, could help to fuel economic recoveries back home, and lead to stronger corporate profits and thus stock market growth. 

To conclude, western stock markets may be on pause as investors try to calculate the probabilities of further lockdowns for the US and the impact that they could have on economic growth. Perhaps we should all cast an eye to the East, as long as China doesn’t experience another wave of Covid, and if the Chinese consumer goes from strength to strength, then we could be worrying about lockdowns in the US for no reason. China was the first epicentre of the coronavirus pandemic, perhaps it will now play a different role and lead us out of the economic gloom.