Recession, China, and the Global Economy

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China’s stock market has been in the headlines so far this year. The slowdown in its economic growth and worries over a global economic recession have sent shock waves through its domestic stock markets and the international investing scene. Official reports say that China’s growth will be slower in 2016 and beyond, and that triggered a response in the global markets. The Shanghai index fell 15 percent in less than a week, and the Dow dipped 400 points in response. Commodity markets also took a hit and gold topped $1107 an ounce.

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Misguided Worry and Inevitability

Many people think that this sentiment is misguided. The Nobel-prize winning Paul Krugman, for one, says that the losses are not large enough to cause the type of investment value slippage that could spark the next big financial shift. The bigger risk is that there is a global momentum that magnifies the impact of any number that comes from China. “And the worse news,” writes Krugman, “is that if China does deliver a bad shock to the rest of the world, we are remarkably unready to deal with the consequences.”

In reality, China’s economy was destined for a slowdown. “The basic problem is that China’s economic model, which involves very high saving and very low consumption, was only sustainable as long as the country could grow extremely fast, justifying high investment,” explains Krugman. “This in turn was possible when China had vast reserves of underemployed rural labor. But that’s no longer true, and China now faces the tricky task of transitioning to much lower growth without stumbling into recession.” Chinese stocks plunged as a result, and stock prices worldwide spiraled downward – but the sky is not falling, yet.

Everything in Perspective

Some people point out that prices are becoming artificially deflated, created a buying opportunity. That may exist in some markets, but those opportunities probably won’t come from China, at least not for some time.

“Will China regain its footing and again boost global economic growth, as it did following the global financial crisis of 2008-09? To do so, the Middle Kingdom would have to dramatically rebalance its economic model, making it less export-driven and more consumer-based,” says Jonathan R. Laing for Barron’s. “And this is unlikely, given the imperatives of a nation in which control by the Communist Party and personal, but not societal, wealth enrichment are paramount values. In fact, chances are that the Chinese economy will get far worse in 2016.”

Even still, as BNP Paribas Wealth Management’s chief investment officer, Florent Bronès points out in Barron’s, as scary as things have been in the stock markets so far this year, the markets themselves are really not that volatile when you consider them on a historical basis.

Now that does not mean that the Bulls are right – market momentum is a real phenomenon. If the Bears yell the loudest, it can trigger a domino effect, but that does not mean that putting all your money in long-term Treasury bonds or other low-yielding cash investments is the answer. Cash could lose more than stocks if the markets really do crumble and there is a very real risk that the return on your bond will not outpace inflation. Then there is the risk of a recession.

Impending Recession

There is a market rebalancing going on, and there are likely quite a few investments that are going to go down in price. Fortune says that the risk of recession is under 50 percent for 2016, but that the odds should increase in 2017. According to Bloomberg, junk bonds are signaling a 44 percent chance of U.S. recession in the next 12 months.

One possible issue is expansion. The economy has been growing for over six years, and the average expansion since 1945 is less than five years. Although we have seen expansion as long as eight years, that milestone is quickly approaching. Moreover, U.S. growth is around 2 percent a year, which is subpar, but not unusual compared to other developed countries.

Oil is another issue. Of course, oil is a “consumption commodity” so if China is not using as much as it was, and the country was using a bunch as it beefed up its infrastructure, there is bound to be a decrease in price. Errors regarding China’s continued demand for oil may have led to an overestimation, and this meant that the price was affected. Morgan Stanley says that oil could go as low as $20 a barrel. This is not surprising given that oil has already dipped under $30 a gallon in recent days – it was the first time that had happened in 12 years. Economist Hung Tran of the Institute of International Finance says that commodity prices rose 80 percent from 1999 to 2011. The assumption was that China had an appetite for raw materials that could not be quelled. Now price indexes are 50 percent down from their peak.

Strong employment will help, but as the stock markets become more volatile, there is a risk of a “negative wealth effect” in which people feel poorer because of higher interest rates or a declining stock portfolio, so they spend less even though they still make as much money as before. The Washington Post notes that the wealth effect for stocks can be as high as 12 cents, and that is bound to have an effect on company earnings and stock prices by extension.

The Bottom Line

The takeaway is that what goes up must come down – and investors should keep in mind that no investment rises in perpetuum – but fears over the state of the global economy are going to cause some market inefficiencies that a sophisticated investor can exploit to advantage.