From January 1st through last week, US stocks traded in a very tight range of +1%-+4% gains YTD.
Last week, turmoil in Chinese stocks markets flowed into US markets, taking stocks down 6.1% for the month of August and down 3.0% on the year. We are taking NO action to rebalance accounts due to last week's pullback. Our clients' accounts are well positioned to ride out this storm.
As we wrote in our mid year report "Stocks SHOULD have sold off 5-10% sometime during the first half of the year as the employment situation and corporate earnings failed to impress. With both poised for improvement in the second half of the year, we now lift our expectations of S&P 500 gains to 6% for 2015." We had to wait a few extra months to see the correction we expected, but our conclusion about year end gains remains unchanged.
Why China, why now?
In recent years, many observers forecast that China would become the world's largest economy, surpassing the United States by the end of the current decade. We were skeptical of that forecast: Too surpass the United States, China would have to successfully manage the transition from an export driven economy to a consumer driven economy.
China from 1980-present mirrors the United States from 1870-1930. Mass production was invented by British textile manufacturers, but perfected in the mills and works shops of the US - shoes & clothing, household goods, processed food, and light machinery. Incredible wealth flowed from production but also enormous divergence in economic equality and increasing mistreatment of average workers. Agrarian workers suffered as mechanized agriculture replaced family farmers ("The Grapes of Wrath"), and farm prices collapsed. Bank credit and loans soared, including the introduction of buying stocks on margin. Housing and stock prices soared. The increasing imbalances were resolved by the stock market crash of October 1929, which wiped out 90% of stock market capitalization, and plunged the nation into the Great Depression.
China is going through the EXACT SAME experience as Chinese agrarian workers migrate to the cities in search of work. Even under the Communist regime, incredible disparities in wealth create social friction. China's governing body is institutionally incapable of managing the transition, so social pressures are building. China implemented a one child policy in 1960 (relaxed in recent years) which created two demographic problems:
- Not enough young up and coming workers, so now rapidly rising labor prices.
- A lopsided sex ratio of 121 boys to 100 girls. Few things are more dangerous to social stability than an inventory of young men unable to find wives and start families.
China experienced a credit bubble, first seen in real estate prices, more recently in stocks prices which gained 140% in the year through June 2015. In the last 8 weeks, however, Chinese stocks declined 35%. Millions of novice Chinese investors are trapped in money losing, margined positions. "Circuit breakers" suspend stock trading once the price has moved 10% in either direction. A stock opens, falls 10%, and then no more trades can be done that day. Chinese consumer confidence and consumer spending are in free fall as consumers savings shrink daily.
What happens next? The Great Depression trapped US economic growth for a decade. Realistically only the economic stimulus of World War II enable the US complete its transition to a consumer based economy (the happy days of the 1950's and 1960's.) The more relevant model may be Japan. At the peak of Japan's stock market in 1989, the value of Japanese real estate that of the US, while the market cap of the Nikkei exceed that of the NYSE. Yet Japan's sclerotic government, similar to China's, has been unable to address underlying condition, and instead applies band aid solutions. Japan's stock market has never exceeded half of the 1989 peak, and the Japanese economy has endured multiple recessions over the last 25 years. Japan's population will shrink for the next 50 years as economic pressure caused the birth rate to collapse.
United States: Once again the locomotive of the world economic growth?
Six years after the "Great Recession" the US economy is hardly robust. GDP is at record levels, and unemployment is at the lowest level in 8 years, but the employment rate (percent of adults at work) remains depressed as many workers have chosen early retirement or disability rather than chase jobs that don't exist anymore. The Fed will probably raise rates from 0% to 0.25% in September. Further increases will be few and far between as long as inflation remains below 2%. Collapsing energy and commodity prices in 2015 will cause prices to rise only 0.1%. In 2008, the most recent "boom year" inflation was 3.8%.
Still, anecdotal evidence suggests that labor markets are tightening. State and local governments are flush with tax receipts, which suggest that business and consumers are doing better. The New York Times reported recently that school districts are unable to find enough qualified teachers and are resorting to students still in preparatory programs. It is cheaper (net of energy, labor and transportation costs) to produce high value products such as MRI machines in Connecticut than in Shenzhen. As recently as 2008, Phillips, GE and Siemens moved factories to China to access lower labor costs and new markets; "Reshoring" is the new buzzword. In particular, US energy costs are the lowest among major industrialized nations.
The pace of economic growth in the US will remain uncomfortably low over the next several years, but we see the US as providing enough demand to pull along China, Europe and emerging economies.
As we said in our July 5th report, we simply must wait until US corporate earnings pick up before we'll see the next up leg in stock prices. The volatility we experienced last week was unpleasant primarily because we have seen very little volatility in this very long bull market (6 years and counting.)