The rally in stocks off of the August low has in some respects alleviated worst case fears about the fate of the Chinese economy. After all, in hindsight it is pretty clear that the selloff was driven by a simultaneous rerating of Chinese growth expectations by market participants combined with the possibility of higher short rates in the US to boot. These fears resulted in vast under performance of growth sensitive asset prices throughout the correction and then a sharp rally in those assets in the days following its terminus.
Yet, when viewing the financial markets as a discounting mechanism in which prices represent the probabilistic outcome of future events, the path of asset prices since the August low has not convinced us that China is indeed “fixed”. If the prospects for Chinese growth had improved we would expect to see those better expectations represented by higher prices in things like copper and oil, and outperformance of growth sensitive sectors of the stock market like materials, industrials and energy. Instead, we’ve seen exactly the opposite. After a very brief (8-11 day) rally in Brent crude oil and copper, Brent is below its price of three weeks ago and copper is just three pennies away from taking out its August low to make a new cycle low (charts 1 and 2). Emerging market stocks in the energy, materials, and industrials sectors have followed a similar path in that they rallied for 19 days following their August low and have since turned right back around and are either at new cycle lows or are testing that August low (charts 3-5). But developed market stocks in those sectors rallied for an even shorter period of time and then fared even worse after the initial bounce. The DM materials and industrials sectors have already breached their August lows and the energy sector is within just a few percent of that important low (charts 6-8).
If we are to take the market’s discounting at face value then the conclusion that China is not “fixed” is as clear as day. In contrast, the financial markets are telling us that the outlook for cyclical areas of the economy – those most closely linked to Chinese economic growth – has deteriorated. Such a scenario could keep a lid on interest rates as well as keep a relative bid under the less cyclical areas of the stock market.