The China Syndrome

Shanghai Stock Exchange Composite Index

The recent stock market sell off owes little if anything to fundamentals, and everything to herd mentality. Nothing we found out when the sell off began was anything we didn't already know. China's economy is slowing, energy supply still exceeds demand and is US interest rates are likely to rise towards the end of the year. We've known all this for months, so why the panic in US markets?

It was a knee-jerk reaction to a sell-off in China. That in turn was a bursting of an equity bubble that had been created after the run-up in property prices stalled and many of China's new-to-the-market fairly naïve investors were looking for the next big opportunity. Many were over-extended and had to sell as market began to turn down, turning a gentle slide into a route. But that was always going to happen - PE ratios were absurdly high and prices had become completely disconnected from the underlying fundamentals. (Even now,they are probably too high - the market is 50% above where it was 18 months ago).

But instead of looking at China's melt-down as just a much needed market correction and not an indicator of any real change to the economy, investors in Europe and the US panicked and rushed for the exits too.

That may be over-stating the case. There are several ways in which the "China Syndrome" might impact US companies. First the Chinese government's response (lowering interest rates and devaluing the Yuan) were hurried and cast doubt on the Party's ability to manage the market economy it is creating. Second, the devaluation and the denting in consumer confidence among China's neauveau riche will hurt consumer technology and luxury goods sales; much of Apple's recent profit growth has come from China.

But the scale of the investors' reaction in the US vastly outweighs the impact of a likely 1% reduction in China's GDP this year (which we already knews was on the cards). If US companies relied exclusively on China for sales and profit, then the drop in US stocks would be in the right ball park - but US exports to China ($123bn in 2014) account for less than 1% of US GDP ($17.4tr). Granted other countries to which the US exports might also themselves export to China so that the effect is larger than just the US' trade with China; but even so the reaction seems quite out of proportion with any reasonable estimate of the impact of  China's slow-down on the US economy.       
    
All of which supports my contention, an observation I made to a finance colleague 20 years ago, that finance is less about pricing of assets and risk than it is a function of rumour, social network and herd behaviour. If expectations of the present value of future cash flows determined asset prices none of last week ups and downs would have happened.