The turmoil in stock markets around the world is being blamed on the crash of the Chinese stock market. This is partially true, but it really doesn’t tell the whole story. Let’s take a minute to look a little deeper into the issue.

To start, one has to understand what is considered the “Chinese stock market”. Such references usually refer specifically to a stock market in which only Chinese investors can invest. This market is typically referred to as “A shares”. Another market, which consists of established companies on the Hong Kong stock exchange, allows foreigners to invest and is referred to as “H shares”. The A shares market is very much a gamblers market that has been compared with our own NASDAQ market of 1999, but on steroids. The average holding period for an A share stock is 5-10 days compared to a holding period of over 250 days for H shares. Margin interest in the A shares market was the highest ever for any exchange in modern history just a few weeks back. The market was ripe for a correction.

Given this background, it begs the question: “Does a stock market only available to domestic citizens really matter to our market?” The normal answer is no, unless there are other underlying problems in the Chinese economy.

The next question becomes: “What, if any, underlying problems exist in the Chinese economy, and are there other underlying problems around the world?” In our opinion, there are two significant problems in China. Number one is the likelihood that the “official” Chinese GDP numbers are accurate is pretty low. For example, a data point to look at is electricity usage. How can their GDP grow by 7% over the last year when electricity usage was only up 3.6% over the same time period? One possibility is that China’s economy became extremely energy efficient over the past year, but we have a hard time believing that. If that were the case, the air quality in cities would have vastly improved. The second red flag is that Chinese exports actually dropped 8% in July and the Chinese purchasing manager index sits at a 6 ½ year low, both of which indicate the economy is shrinking, not growing.

Is the slowdown just in China? Probably not. Trading is down worldwide. If we look at trade data between the United States and Canada, our number one trading partner, we see that the U.S. dollar appreciated quite significantly versus the Canadian dollar. With this appreciation, U.S. goods cost more to Canadians so it would make sense to see our exports to Canada decreasing. According to April data published in the “Journal of Commerce”, exports via trucks were down 5.7% year-over-year and 13.9% via rail year-over-year. Imports from Canada to the U.S. were also down over the same period, by 7.8% via truck and 2.1% via rail. Looking at this data in conjunction with the drop in exports from China, we begin to see a picture showing less trading activity around the globe. Less trading activity means a slowdown in economic growth, which means lower corporate profits. Lower corporate profits means companies are worth less.

So, as we have said previously, investors can make money in any economic environment. It simply comes down to the price you pay for an asset. Trade may only be 14% of our GDP, but given both the continued strengthening of the dollar and the reduction in trade activity, large U.S. companies may continue to see pricing pressure moving forward. We currently have the lowest exposure ever to large cap equities in our history. We continue to see opportunities in emerging markets, as well as certain other parts of the U.S. markets.

Book of the Month – Asia’s Cauldron – The South China Sea and the End of a Stable Pacific – Robert D Kaplan

Most of the time, the problem child in Asia is North Korea. This book explores the rules of navigation in the South China Sea and how they may be changing over the next decades as China becomes more dominant. Other Asian countries are getting prepared for this change by spending significant amounts on of money on weaponry. As the book mentions, Vietnam recently spent $2 billion on 6 Russian submarines and $1 billion on Russian fighter jets. Arms imports to Indonesia are up 84%. For Singapore and Malaysia, it is up 146% and 722%, respectively, over the same period.   China has a long, proud history of superiority in the South China Sea that has diminished over the last 150 years. This book lays out the current situation in the South China Sea and what it means to the world. This is an excellent book to learn more about this area of the world and how it is changing.