Economic & Market Report: Red Alert

The U.S. stock market has hit a rough patch in recent weeks. Just as notable has been the sharp rise in U.S. Treasury yields over the past month. While it is understandable for U.S. investors to look inward in seeking explanations for why both stocks and bonds are performing poorly as of late despite a domestic economy that remains solid as it continues to shed inflationary pressures, the more likely culprit for recent market woes may be coming from overseas from the world’s second largest economy in China.

We’ve seen this story before. Remember the “Taper Tantrum”? More than a decade ago now on Wednesday, June 19, 2013, then Fed Chair Ben Bernanke took to the podium after the latest FOMC meeting to say that the Fed maybe, kinda might think about possibly scaling back on its QE3 asset purchases perhaps at some point in the months ahead, maybe. Supposedly, these words from Bernanke sent U.S. stocks plunging lower and U.S. Treasury yields spiking higher for the next several trading days despite a chorus of Fed member backtracking and reassurances along the way until Monday, June 24 when the downside pressure finally relented.

What is almost never recalled from this episode was the crisis that was unfolding at the exact same time. For it was on that very same day on Wednesday, June 19, 2013, that the Chinese banking system was entering into its own seizure following an active effort to drain liquidity from their own financial system to reduce systemic risks. Financial institutions in China stayed open late that day in a frantic effort to secure liquidity as banks were becoming increasingly reluctant to lend funds to one another. By the next day on Thursday, June 20, the overnight lending rate in China had spiked into double-digit territory, suggesting that liquidity in the banking system was quickly drying up. Initially, the People’s Bank of China (PBOC) declared that sufficient liquidity existed in the financial system, and markets recoiled further. It was not until the PBOC finally intervened with targeted liquidity injections on – wait for it – Monday, June 24, 2013, that the Chinese financial system finally calmed down.

A few more past examples. Remember the U.S. stock market flash crash that took place on Monday, August 24, 2015? What is almost always forgotten is that China’s Shanghai Stock Exchange Composite entered into a freefall four trading days earlier on Tuesday, August 18, shedding nearly -30% of its value in the process as Chinese authorities actively worked to prick the stock market bubble they had grossly overinflated earlier that summer.

And remember in November 2016 the massive 57 bps spike in the 10-Year U.S. Treasury yields from 1.79% to 2.36% in the days following the U.S. Presidential election that was supposedly caused by the reaction among U.S. investors to the unexpected political outcome? Turns out we learned a few months later from the Major Foreign Holders of Treasury Securities report from the U.S. Treasury that the primary cause for the spike in yields was selling from China and that U.S. investors were actually net buyers of Treasuries during this time period.

These are just a few examples of sudden and sharp downside events taking place in U.S. markets whose attribution at the end of the day ends up coming from the other side of the world in China (and even if the conventional historical narrative still remembers it differently).

So what’s happening in China today? The China economy has already been struggling for months. The much ballyhooed economic surge from the world’s second largest economy coming out of its latest national bout with COVID earlier this year (yeah, this is still a major issue in some parts of the world) has failed to materialize. Instead, the China economy is grappling with insufficient domestic and foreign demand coupled with a deepening property market crisis. The latter has included the bankruptcy declaration of Evergrande Group, once China’s second largest property developer, and the debt restructuring of major Chinese asset management firm Zhongzhi Enterprise Group, a major player in China’s $3 trillion shadow finance system. And if we learned anything from the Great Financial Crisis here in the U.S., major financial institution failures bring with it major spillover effects and widespread financial asset liquidations.

So what have we seen in recent weeks as these events in China have unfolded? The Shanghai Stock Exchange Composite has plunged by nearly -7% since the end of July to its lowest levels of the year. The Chinese yuan has also depreciated by as much as -3% relative to the U.S. dollar in recent weeks and more than -8% year to date.

What about in the U.S.? Over virtually the same exact time frame since the decline started to unfold in China, the S&P 500 has dropped by -6%. As for U.S. Treasuries, of which more than $1 trillion is owned either directly or indirectly in China, the yield on the 10-Year U.S. Treasury has spiked in recent weeks by nearly 60 bps to their highest levels of the year. Even the highly liquid precious metals of gold and silver have shed as much as -4% and -13% since the end of last month.

Bottom line. As a difficult August draws to a close and investors seek direction on where U.S. stocks and bonds are heading as the historically more challenging month of September gets underway, keep a close eye on events coming out of China. If conditions continue to deteriorate, it may be difficult for U.S. assets to escape the spillover effects.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Investment advice offered through Great Valley Advisor Group (GVA), a Registered Investment Advisor. I am solely an investment advisor representative of Great Valley Advisor Group, and not affiliated with LPL Financial. Any opinions or views expressed by me are not those of LPL Financial. This is not intended to be used as tax or legal advice.  All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.  Please consult a tax or legal professional for specific information and advice.

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