Smoke and Mirrors

by Brad Houle, CFA Executive Vice President

Gyrations in the Chinese A-share stock market have been a big topic in the financial press recently. The questions that we are getting from clients all center on what the broader implications might be for the Chinese economy and the impact on Western economies. Bottom line, the Chinese A-share market gyrations are a circus side show that will not have real impact on the actual economy of China or the economies of the U.S. or Western Europe.

In fact, the recent events in the Chinese stock market are an excellent primer on what NOT to do while trying to develop free price capital markets. Currently, the A-share market is more rigged than a game of Three-card Monte and the government in Beijing is determined to build the world’s biggest casino. There has been a dizzying array of strategies employed by the Chinese government to first inflate the value of the market and then attempt to control its inevitable decline. Most investors in the A-share markets are Chinese retail investors. The use of borrowed money or margin was encouraged and the A-share market became the most levered financial market of all time for a short while. Since the market started its downward slide, margin debt has now been restricted. In addition, if you are a greater than 5 percent holder of a stock, you are now not allowed to sell for six months. In addition, 200 companies listed on the Shanghai exchange have suspended trading. This is only a partial list of the heavy handed tactics utilized by the government in an attempt to control the stock market. Capital markets that are free from unnecessary regulation and are as transparent as possible are vital to build trust with global investors. While China has gotten it wrong in the short-term, eventually they will get it right as the country transforms to more of a free market economy.

The Chinese A-share market is a rounding error in international equity indexes and Chinese exposure for our clients is accomplished via exposure to Hong Kong and its stock market’s H-shares, as well as Chinese companies that trade on American exchanges. Unless you are a retail investor in China who is invested in the Chinese A-share market, it is not impactful. What is important, however, is what happens in the Chinese economy.

Chinese GDP was released this week at a 7 percent year-over-year growth rate. It is an old story that global investors look at Chinese economic data with skepticism. If you look deeper at other economic indicators in China, the data suggests that a number much lower than 7 percent GDP is probably closer to the truth. One of our research partners, Cornerstone Macro, points out that as business confidence is at the lowest level in 16 years, electricity consumption is up just 1.8 percent, auto sales are down 40 percent and bank loan demand is lower. As such, Cornerstone theorizes that actual GDP growth is likely closer to 5 percent. China is the number two economy in the world, and what happens with the trajectory of the Chinese economy is impactful to the world economy. Currently, the U.S. and European economies appear to be decoupled from the Chinese economy and are benefiting from lower commodity costs and strong domestic economies.

Our Takeaways for the Week

• The Greek parliament voted to enact reforms agreed upon with the European Union this past Thursday. Once again, the “can” of the Greek Financial Crisis is getting kicked down the road
• The Chinese A-share market is unimportant in the global economy. Performance of the broader economy in China is of vital importance to the world economy and the trajectory of growth or lack of growth is something we are monitoring closely

Disclosures

"Putin" Russia Behind Us

by Shawn Narancich, CFA Executive Vice President of Research

Good Friday, Great Week

Shaking off another bout of Russian adventurism in the former Soviet Union, stocks moved further into record territory this week on the heels of a better than expected jobs report domestically and encouraging manufacturing reports both here and abroad. Investors have witnessed a slow but steady reversal of the early 2014 risk-off trade, with benchmark U.S. Treasuries retracing approximately half of their earlier year gains and the S&P 500 now up 7 percent from its early February lows. Despite cold and snowy weather that has put a damper on retail sales this winter, we continue to foresee a stronger U.S. economy this year, supported by a rejuvenated energy sector that is in turn producing a renaissance in U.S. manufacturing.

Decoupling

A monthly jobs report signaling net non-farm payroll gains of 175,000 is not ordinarily a reason to celebrate, but viewed against the cold and snowy weather of one of the nation’s worst ever winters, the fact that February employment gains approached the average levels achieved last year is notable. We are encouraged to observe that local and state employment, after being such a material drag for so long, posted gains during the month, but even more important is the continued employment gains reported in construction and manufacturing. Dovetailing with the detail of today’s jobs number was the purchasing managers report for February out earlier this week, which showed manufacturing expanding at a faster pace domestically. Given the encouraging economic data, we foresee the Federal Reserve continuing to pare its purchase of Treasuries and mortgage backed securities, as likely to be detailed at its next FOMC meeting March 19^th.

This week, investors witnessed Russia’s ruble tumble in response to the country’s Crimea incursion, forcing the central bank to boost short-term interest rates in support of the currency, but also adding to the risk that Russia falls into recession.  With emerging market currencies under pressure and in turn creating inflationary problems beyond US and European shores, we see developed economies that have increasingly decoupled from their emerging market counterparts. Supporting our outlook for the world’s developed economies to outperform in 2014, Europe reported its best retail sales numbers in thirteen years and coupled that with surprisingly strong manufacturing growth.

Tales of the Cash Register

Over the past couple weeks, U.S. retailers book-ended a fourth quarter earnings season that once again produced a clear plurality of better than expected results. For the retailers, hits and misses were as numerous as in any quarter we can recall. On the plus side of the ledger, investors were pleasantly surprised by strong sales at department store operator Macy’s and by the home improvement retailers Lowe’s and Home Depot, which both reported strong finishes to fiscal years advantaged by the rebound in housing. Meanwhile, investors in Radio Shack and Staples were left to lick their wounds, as both these companies continue to suffer from sales lost to the digital economy in general and Amazon.com in particular. Both undershot investor expectations and are in the process of closing hundreds of stores to right-size their disadvantaged business models.

Our Takeaways from the Week

• Stocks forged new highs despite geopolitical tensions in Eastern Europe

• Despite bad weather, the U.S. economy continues to make encouraging progress

Disclosures