Events in China have roiled capital markets over the last several weeks. In just four trading days, from August 19th to August 24th, the S&P 500 Index lost 10.9%. Stocks have recovered a good chunk of the initial losses but in a rather disorderly fashion. One hopes–with some justification–that we’ve seen the worst of the declines.
The roller coaster ride was triggered in Beijing when authorities took markets by surprise in devaluing the yuan and then tried but failed to contain plunging Chinese stocks. China’s stock market is largely walled off from the rest of the world so the direct impact of the crash is limited. The currency devaluation is a much bigger worry, especially if it is the first step in a protracted effort. Given the weak economic data coming out of Beijing in recent months, that may well be the case. A sustained devaluation would hurt neighboring countries such as Vietnam and South Korea that compete with Chinese manufacturers, leading to markedly lower prices for Asian exports. While that will benefit consumers it has the potential to unleash a harmful global deflation.
While there is no doubt that the market declines were triggered in China, it was exacerbated by a U.S. stock market that had climbed too far, too fast over the last several years. We wrote back in July,
“It’s been over three years since the S&P 500 had a 10% correction. That’s significantly longer than the usual time between corrections, so we wouldn’t be too surprised if the drama in Europe [the standoff over Greek debt, since resolved] or the wild swings in Chinese stocks prompt a pullback.”
Further complicating matters is the question of when the Federal Reserve will begin to raise interest rates. The stock market initially took comfort from signals that declining share prices had killed the possibility of a September rate increase. When Fed officials suggested that a September move was still possible, the market reversed course. We may see more volatility until the Fed makes its decision later this month.
While the sheer speed of the correction was unnerving and it’s clear that China will be a wild card for global markets for a long time to come, we don’t expect a significant impact on the U.S. economy. With U.S. GDP growth coming in at 3.7% in the second quarter, rolling four quarter GDP growth has exceeded 2.5% for five straight quarters. Those are solid numbers and suggest that it will take more than the recent events in China to derail the six-year U.S economic recovery. If the situation in China doesn’t worsen significantly, we would view the sharp stock market pullback as a painful but overdue and ultimately healthy correction.
We’ve taken advantage of the market drop to put cash to work for those clients with excess liquidity and will continue to look for opportunities to help clients benefit from any ongoing volatility.