Global stocks have been falling since the start of 2016. The global rout was triggered by the slump in Chinese stocks in the first trading session of 2016 on January 4. The selloff was precipitated by the release of the Caixin China manufacturing purchasing managers index, which fell to 48.2 in December from 48.6 the previous month. This was the 10th straight month the reading was below 50, indicating protracted contraction in China’s manufacturing sector. Global equities followed the plunge in Chinese stocks: The Dow Jones Industrial Average fell 1.58% in the first trading day of 2016, recording the worst start to a year since 2008. Investor confidence was undermined also by the US Institute for Supply Management report the same day indicating the US manufacturing sector contracted further as ISM manufacturing index declined to 48.2% in December from 48.6% the previous month. Trading was halted for the second time in a week on China’s mainland stock exchanges on January 7 as another 7% plunge in CSI 300 index triggered the market circuit breakers, bringing the loss in four sessions to 11.7%. Equities have been on decline since then, with major developed market stock markets incurring similar losses through January 14: S&P 500 is down 4.63%, Germany’s DAX 30 and Nikkei 225 lost 4.68% and 4.57% respectively.
Stock prices are falling on the backdrop of falling commodity and oil prices. Declining commodity prices indicate falling global demand, and slower growth of China’s economy is acting as a drag on global economy. China’s economic growth has been slowing as state financing of investment projects in fixed infrastructure and housing fell. The country now has to rely on growth in consumption and services as it tries to shift from a model of growth driven by investment and exports. Growth in services and consumption last year offset partly the fall in manufacturing and residential construction. The issue is to what extent consumption and services growth can replace investment and exports as new drivers of economic growth. It is a big challenge. Essentially the model of economy has to transform from one dominated by state financial institutions and industrial enterprises into one where private enterprises make capital allocation decisions and produce goods and services based on market demand. This is not the case presently, and the stock market slump that started last August after the equities bubble burst, demonstrates the challenges facing world’s second largest economy. Chinese authorities attempted to artificially boost consumption by engineering a rally which theoretically should induce higher spending and consumption as investors’ equity wealth grew. But stock market bubbles not supported by market fundamentals such as earnings and revenue growth are unsustainable and eventually must burst. This is what happened after a move by People’s Bank of China to devalue yuan 1.9% against the dollar on August 18, 2015. It is not likely that consumption growth will soon replace investment and exports as China’s engines of growth and Chinese authorities will have to rely on familiar measures: stimulate fixed investments in infrastructure and attempt to boost exports. The conventional tools for stimulating investment are monetary easing, which lowers interest rates via increased money supply, and expansionary fiscal policy. Monetary easing was not very effective in accelerating economy’s growth as several interest rate and reserve requirement cuts in the last year failed to prevent the economic slowdown. With majority of state enterprises already receiving financing from state banks and projects directly and operating with what amounts to soft budgets constraints, a major fiscal stimulus package will be needed to increase the growth through higher investment. There have been announcements of new infrastructure projects but no significant changes in budget spending have been announced that would indicate a considerable boost to GDP growth. From authorities perspective an immediate boost to exports looks more attainable through currency devaluation, and recent lower daily fixings of yuan point to China’s decision to boost exports through currency devaluation. But yuan devaluation increases the likelihood that other central banks will also intervene to weaken their currencies, provoking currency wars and limiting the scope of positive impact for exports. In short, there are no indications that China will resume the role of global growth engine any time soon this year, continuing to act as a drag on global economy and particularly negatively affecting economies and stock markets of commodity exporters.
Japanese stocks are set to continue declines as China’s economic slowdown is weighing on exports prospects of Japanese firms while US economic growth remains moderate. Nikkei 225 has almost declined to levels where it was at the time of surprise monetary stimulus expansion by Bank of Japan in October 2014. Bank of Japan Governor Kuroda said no additional easing is being considered at this time, but in case the central bank decides to expand the stimulus program it is certain to reverse the downward trend.
European stock markets are in a similar state with Germany’s DAX 30 and France’s CAC 40 back at levels they were before European Central Bank’s announcement about quantitative easing program in January 2015. As the central bank is anticipated to announce no additional monetary stimulus measures at its meeting on January 21, European equities are also expected to trade with downward bias until investors see not just downward risks for global growth.
The pace of US economic growth now depends on growth in consumption spending as stronger US dollar has limited the US export growth potential at the time when export prices are falling, and business investment is falling with many companies in energy sector cutting capital expenditures. The December jobs report showed a strong increase in nonfarm payrolls to 292,000 from 252,000 but average hourly earnings fell to $25.24 from $25.25 in November. In line with falling earnings retail sales actually fell in December, indicating consumption growth has not materialized yet contrary to policy makers’ expectations that tightening labor market will result in higher wages and spending, eventually lifting inflation. While further gains in employment may yet translate into higher spending and inflation justifying the shift to monetary tightening policy by the Federal Reserve, the fourth quarter corporate earnings are expected to fall. Correspondingly US equity markets are expected to continue declining as investors price in global economic slowdown and deteriorating earnings prospects of US companies with Federal Reserve in tightening mode.
