Should Investors Worry About China?

The rise of stock market indices has caught many investors by surprise this year. In fact, most research firms were anticipating a recession and the positioning in managed funds coming into 2023 was on the defensive side. While there are many factors that drive asset prices in the short term, over the long term asset prices are related and can tell investors a lot about the current backdrop and also expectations of the future. Sometimes these asset prices agree and other times the relationship breaks down which can provide an opportunity moving forward.

At the beginning of the year, there was much hype around the reopening of the Chinese economy from much stricter lockdown measures than the rest of the world. Being the second largest economy in the world, this was important because if the Chinese economy reacted the same way as the rest of the world, it would act as a big tailwind to the global economy. As you can see below, the Chinese High Yield market which had led the market downturn in 2022 and the rebound in 2023 has started to turn aggressively lower again.

Source: Bloomberg

What makes this most interesting is it is creating divergences between asset classes. Divergences happen all the time, but the larger they grow and the longer they last, the greater the chance of mean reversion. One of the things that has been highlighted throughout much of this year is the fact that the S&P 500 returns were being dominated by the largest 8 companies and the average stock was not rebounding this year.  In June and July the amount of companies participating in the rally started to increase and to many this was an all-clear sign for markets to go back to all-time highs. 

One of the things I like to look at is how other assets are confirming the change in trend and how sustainable the move is. With the second largest economy in the world appearing to have more credit issues, how long until this becomes a drag on the rest of the world.  Another narrative that was prevalent this year was the idea that the Federal Reserve would stop hiking rates and that would let the economy expand again as inflation came back down. The issue with inflation, as we saw in the 1970’s is that it comes in waves and can move much further than expected both to the upside and the downside. 

What is interesting about this inflation/deflation dynamic is that while it appears to be sticky in the United States, the problems in China are becoming more of a deflationary problem than one of slowing inflation.  It will be very difficult for the rest of the world to remain in an inflationary environment with China in a full fledged deflation.  As you can see below this is being born out in the sovereign bond market. Over the last year, the Chinese 10 yr yield has led the US 10 yr yield to both the upside and the downside until the end of April.  At the end of April, Chinese 10 yr yields continued to fall while US 10 yr yields are now approaching cycle highs.   

Source: Bloomberg

While this can continue for awhile, the longer this continues the more likely we are to have a nasty mean reversion. This could be from US yields dropping or Chinese yields rising or some combination of both.  As I stated earlier, asset prices are interrelated and how these yields mean revert will be very telling on what happens to other risk assets.  While a lot of the headlines continue to focus on slowing inflation, a pausing Federal Reserve, a resilient US Consumer and job market, and Artificial Intelligence it is time for investors to pay attention to what is happening in China because no one is positioned for the potential negative effects of their problems being exported to the rest of the world.