The China Factor

The S&P500 slipped about 0.35% last week on light volume. S&P volatility didn’t change much—it remained near multi-year lows. In other words, investors are still extremely complacent and not fearing any significant equity market drop.

At the same time, confirming this market complacency is the fact that market prices, despite last week’s tiny pullback, remain near record highs. While the upward momentum on the daily charts is slowing, the technicals point to the possibility of more gains. On the weekly charts, the recent downturn in momentum looks like it’s on the verge of reversing to the upside. So the technicals are saying that while prices are stretched to the upside, even more gains are possible…..at least in the near term.

In terms of US economic data, the story has not gotten better—US macro data is still coming in on the weak side of average. Job openings from the JOLTS survey are not growing much. Retail sales disappointed—at both the headline and core levels. Consumer prices shocked everyone because the core figure on a month to month basis came in at half the expected rate. Even worse, on the year over year basis, the rate dropped below 2.0%, which is the Fed’s important threshold for monetary stimulus; if inflation is below 2.0%, then the Fed usually favors more stimulus. The problem now is that the Fed has started a tightening program but inflation has fallen below its minimum target. On the positive side, business inventories came in stronger than expected and so did consumer sentiment.

Finally, most investors are not aware of the huge role that China has played in the global recovery from the great recession of 2008-2009.  Both its fiscal and monetary stimulus were massively increased, unleashing a powerful reflationary impulse that pushed not only corporate profits around the world upwards, but also many other factors including commodity prices and financial asset prices.

The downside to all this is twofold. First, China financed this huge multi-year stimulus primarily by issuing trillions of dollars (or dollar equivalents) of debt, debt which has now reached such high levels that additional future borrowing has become more difficult to accomplish. Second, the entire policy decision to undertake this stimulus rests with the Chinese government, not the US and not Europe (our allies). So the decision to pull back on such huge stimulus would clearly rest with this same entity, the Chinese government.

Why is this important? Because the Chinese government has recently begun taking measures to reign in its debt growth and as a result, the world could be in for a shock…..because the same stimulus that has propelled the world to recovery over the last eight years may go into reverse and become a deflationary impulse, which could unwind many of the benefits achieved since the stimulus began.

So it will pay investors to watch China closely!

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