Apres China Le Deluge?

China’s stock market has been in the news due to its recent plunge.  The plunge follows a strong run up over the last year. Whatever the reason for the spike up and the subsequent dive, this is a Chinese problem whose consequences will be felt largely by the Chinese. Far more profound is the effect that China has had on commodity markets and investment in many emerging market countries since 2001.

Due to China’s effects on commodities and the economies of many emerging markets, developed market equities are likely to continue outpacing EM equities.  Traditional cyclical industries like energy, materials and manufacturing should probably be kept underweight too.

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China developed its economy at an unprecedented pace from 2001, when it joined the World Trade Organization, until recently. Commodity prices rose almost 5 1/2 times or almost 30% a year between 2001 and 2008 on the back of China’s boom.  That boom paused and then reaccelerated as China indulged in a massive credit stimulus during the global financial crisis, but has been unwinding since late 2011.

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Investing themes during the boom included buying equities from commodity producing countries and equities tied to the emerging market consumer. It was supposed that EM consumers were all being pulled into the middle class by the China boom.  The currencies of commodity producing nations did well too, so much so that they could have substituted for EM equities with the additional of some leverage.

Those themes have gone by the boards.  Investment that was spurred by the China boom has been cut and will continue to be cut.  Petrobras cutting its capital budget is the latest example.  The first decade of this century was unusual, because commodity prices outpaced the prices of manufactured goods.  That happened because commodity prices are inelastic in the short run. Energy and metals prices could stay low for years due to the supply that ultimately was brought on line in the boom.

Many emerging countries, like China, Brazil, Turkey and Indonesia also became overly leveraged as they tried to prolong their booms.  It will take years before they can work off the excess.  Expect their growth to remain slow for several years.



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