How Much Will China Affect Your Portfolio?

China Correlations

When Apple reported its fourth quarter earnings earlier this week, Tim Cook, the company’s CEO, noted signs of “economic softness” in the greater China region. Apple’s stock fell by more than 6% the next day. While China wasn’t solely responsible for this decline, it highlights how economic conditions on the other side of the world can affect US investors. How much will China’s financial travails affect your portfolio?

You can have direct exposure to China by owning stock in Chinese companies (for example through mutual funds and exchange traded funds). As Apple shows, you can also have indirect exposure to China through companies based in other countries. The iPhone maker gets almost 25% of its revenue from greater China (meaning China, Hong Kong, and Taiwan). Apple is something of an outlier, however; overall only about 2% of large US companies’ revenue comes from China.

The Chinese economy can also indirectly have an impact on companies around the world in other ways, such as by affecting commodity prices. So which countries are most closely tied to China? The graph above shows the correlations between the movements of Chinese stocks and many of the world’s other large stock markets during the past three years. Correlation is a statistical measure of how closely two things move together, where a correlation of 1 means they move in lockstep and -1 means they move exactly opposite each other.

Other countries in the Asia Pacific region—South Korea, Taiwan, and Australia—have the highest correlations with China. Interestingly Japan, China’s neighbor across the East China Sea, has the lowest correlation of the countries examined. The US is in the middle of the pack.

Perhaps the most striking aspect of these correlations, however, is that they’re all fairly closely bunched together. By contrast Chinese stocks have a correlation of only 0.35 with commodities, and a correlation of -0.14 with US investment grade bonds. That’s probably not because Chinese itself has a large effect on all the different countries’ stock markets, but rather that the same factors that affect Chinese stocks (such as the outlook for the global economy) affect stocks all around the globe.

So while some particular companies (such as Apple) and some particular countries (such as South Korea) may add some additional “indirect” China exposure to your portfolio, it’s important not to lose sight of the bigger picture. No matter what happens in Chinese markets, your investment performance is likely to be driven more by your broader exposure to different asset classes than by particular companies or countries.

How China Affects American Markets

China Exchange Rate

China’s financial markets have been making headlines recently, and generally not in flattering ways. First its bubbly stock market soared and subsequently crashed. Then concerns spread about the country’s slowing economic growth. This week the country’s central bank reduced the value of its currency, the yuan. How much will these events affect financial markets in the US?

At first glance the effects on the US should be mild. Though China is the world’s second-largest economy, its financial markets are not a commensurate size. It makes up less than 3% of the MSCI ACWI, an index representing the global stock market. Only about 2% of large US companies’ revenue comes from China. And as of last year less than 1% of global currency transactions involved yuan.

The most recent upheaval—the decline in the value of the yuan—wasn’t even particularly large. The currency fell by a few percentage points against the US dollar over the course of two days. While such a move is unusual for the yuan (which the Chinese government keeps loosely pegged to the dollar) it pales in comparison to other currency movements. Russia’s ruble, for example, fell by more than 30% against the dollar in a single month at the end of 2014. And the US Dollar Index, which measures the value of the dollar against a handful of other currencies, has risen during the past year, meaning that the yuan is still far worth more compared to most currencies than it was 12 months ago.

China’s financial market turmoil could still end up having a sizable adverse effect on the US, but only to the extent that it may signal more bad news to come. The decision to let the value of the currency decline, for example, could indicate that the economy is doing worse than publicly-released data suggests. It’s also possible that the currency devaluation was just the first step in longer-term effort to try to boost the Chinese economy by weakening the yuan. Such a shift could cause both economic and political trouble in the US.

Should You Worry About a Chinese Stock Market Bubble?

Shanghai Skyline

China’s economic growth has recently been characterized by diminished expectations. Over the past decade the economy of the world’s most populous country has often handily exceeded the government’s usual target of 8% annual growth. But last year the growth rate failed to meet the government’s reduced 7.5% target, and in March the government reduced its target for this year to 7%. Yet despite these disappointments, Chinese stocks have been among the world’s best performers so far in 2015. Is that dichotomy a worrying sign that China’s stock market gains will prove ephemeral?

Many experts believe the answer to that question is “yes,” and there’s evidence to back up that view. Price-to-earnings ratios for many smaller companies are over 100. Chinese citizens have opened new trading accounts in record numbers. The amount of margin financing (debt being used to buy stocks) has soared. These are all classic signs of a stock market bubble.

But US investors—even those with substantial exposure to Chinese stocks—may be largely isolated from this ostensible bubble. While valuations on many smaller Chinese companies do seem excessive, those for the larger companies that make up the bulk of the stock market are more in line with historical norms. By some metrics Chinese stocks overall may even be undervalued.

Furthermore, US investors (through the funds that they invest in) typically own shares of Chinese companies listed in Hong Kong rather than mainland China. Since late last year the value of the stocks listed on the mainland has surged, and on average they’re currently about 30% pricier than the Hong Kong shares of the same companies. That might be further evidence of investors being irrational, but it also suggests that US investors will be hurt far less than mainland Chinese investors if stock prices decline.

US investors aren’t completely isolated from the bubbly nature of some Chinese stocks: a dramatic loss of wealth for Chinese investors could reverberate throughout the country’s economy and stock market. But bigger-picture issues, such as whether the government can successfully manage the slowdown in the economy’s growth rate, are likely to be more important.

The Big Trends in the Global Economy

Global Growth

A lot has seemingly happened in the global economy in recent months, from a plunge in the oil price to a surge in the value of the US dollar against foreign currencies to an election in Greece that led to renewed fears about the possibility that the euro zone would break apart. But what’s been the upshot of all these changes? The latest World Economic Outlook report from the International Monetary Fund provides some data to answer that question.

According to the IMF’s report, the global economy is expected to grow by 3.5% this year. That’s lower than the projection of 3.8% growth that the IMF made six months ago. The change is largely the result of slower expected growth from emerging markets (5.0% six months ago versus 4.3% now). The prospects for developed economies, on the other hand, have actually improved slightly. While the estimated 2015 growth for the US hasn’t changed (it’s still 3.1%), the IMF boosted its growth estimates for the euro area and Japan.

Even though expectations have declined for emerging economies as a whole, not every country has a similar story. Six months ago the IMF expected a positive growth rate this year in Russia and Brazil; now it expects both countries’ economies to get smaller. The anticipated growth rate for China has also declined, although it’s still very high at 6.8%. India has gone in the other direction. Six months ago the IMF was projecting that India’s growth this year would be 6.4%. The latest estimate is 7.5%.

It’s important to remember that there’s only a weak link between economic growth and stock market performance, so simply buying stocks of fast-growing countries (or stocks of countries where the economic outlook has improved) probably isn’t a good idea. In fact, China and Russia have been among the best-performing stock markets so far this year. Still, thinking about the global economy in terms of these numbers may make the big-picture trends more apparent.

How Fast Will China Grow?

China GDP

For many years China experienced extremely rapid economic growth, with its GDP often growing by more than 10% in a year. In the last few years its growth has slowed a bit, and the International Monetary Fund (IMF) projects that its growth rate will fall to 7.3% next year and 6.5% by 2019. While this is a substantial decline from some of its sky-high growth rates in previous years, these numbers still represent very rapid growth. By comparison, US economic growth has averaged less than 2.5% per year during the past 5 years.

But can China continue to grow so quickly? New research from two Harvard economists, Lant Pritchett and Larry Summers, suggests that China’s growth rate may fall more than the IMF projects. They find that how much an economy has grown recently doesn’t tend to have much impact on how much it grows in the future. Their calculations show that China’s growth rate is likely to average less than 4% over the next 20 years.

There’s only a weak link between a country’s economic growth rate and how well its stock market performs, so a slowdown in China doesn’t necessarily spell doom for Chinese stocks. It’s very plausible that Chinese stocks could do well even if the country’s economic growth continues to slow as the IMF projects.

But part of the reason the link is so weak is that investors can anticipate when the growth rate is going to increase or decrease and “price in” this change before it actually occurs. It’s unlikely that investors have already priced in a decline in the Chinese growth rate as dramatic as the one Pritchett and Summers project. If their pessimistic forecast comes to pass, the performance of Chinese stocks is likely to suffer.

Can Australia’s Winning Streak Continue?

Australia Stock Returns

The past two decades have been tough for most international developed economies. Japan has experienced mediocre economic growth for the past 25 years. Europe has recently suffered through two recessions as it battled the global financial crisis and then a sovereign debt crisis. Australia, by contrast, has been a star of the global economy: it hasn’t had a recession since the early 1990’s. Its stellar economic performance is a key reason why its stock market has returned an average of 12.4% per year over the past 10 years, compared with 6.8% for international developed markets overall. Can its winning streak continue?

There are two common explanations for Australia’s success. One is that Australia’s central bank, the Reserve Bank of Australia (RBA), has done a masterful job of managing the country’s economy. The other is that Australia simply piggybacked on the booming economic growth of China, its largest trading partner.

If Australia’s success was just a side effect of China’s economic surge, that may not bode well for Australia’s future prospects. China’s growth rate has slowed from over 10% a year for much of the previous decade to less than 8%, and it may fall further as the Chinese government seeks to rebalance the country’s economy.

If the cause was instead the RBA’s adroit central banking, perhaps the outlook for Australia’s economy is sunnier. In theory the central bank could manage the fallout from a slowdown in China’s growth, though there’s certainly no guarantee that successful economic management in the past will mean successful economic management in the future.

There’s probably some truth in both explanations for Australia’s success, though the RBA’s job is likely to be more difficult than it was in the past. Its benchmark interest rate is at a record low level, giving it less room to further reduce interest rates in order to boost the economy. If China’s economy continues to slow, Australia will struggle to keep its economic winning streak alive.

The Biggest Political Risk

China-US Diplomacy

We recently discussed the rise in political risk that investors have had to deal with over the past few years. But where is this risk most likely to have a meaningful impact on US investors? The answer, perhaps surprisingly, is East Asia.

That answer may seem odd given the political uncertainties in other parts of the world. Syria has been racked for years by a deadly civil war, Iraq’s government is trying to fight off an insurgency, Russian-linked separatists have been stirring up trouble in Ukraine, and military leaders have claimed power in countries such as Egypt and Thailand. But when it comes to global financial markets, these countries are bit players. Even Russian stocks comprise only about one half of one percent of the value of the global stock market. While it’s true that events in small countries can have an impact—trouble in Syria or Iraq could spread throughout the Middle East and affect global oil supplies, for example—political risks related to larger countries would be more consequential.

Since 2012, a diplomatic conflict has been escalating between China and Japan over a group of uninhabited islands in the South China Sea. China also has territorial disputes with other countries in the region, including Malaysia, the Philippines, and Vietnam. So far these conflicts have remained mostly diplomatic rather than military disputes, but there are routinely provocations that threaten further escalation. Last month China stationed an oil rig in territory claimed by Vietnam, leading to riots in Vietnam targeting foreign businesses.

A military conflict between any of these countries could roil financial markets: Japan is the second-largest country in the iShares MSCI All Country World Index ETF, while China is the ninth-largest. Furthermore, the United States could intervene in such a situation (the US has a security agreement with Japan), making the strife truly global.

The good news is that the probability of a large-scale military conflict is still very low. Yet even if the disputes remain the purview of diplomats, investors could feel some effects: trade between China and Japan has fallen substantially since their territorial squabble metastasized in 2012.

Q1 Recap: US Stocks Overcome Russia, China to Stay in Positive Territory

The first quarter of 2014 had a few bumps in store for financial markets, yet in the end almost every asset class ended up with positive returns. Bonds performed well as interest rates declined and the US inflation rate remained below the Federal Reserve’s 2% target. US stocks recovered from January jitters to end the quarter in positive territory. Even emerging market stocks, buffeted by fears of financial instability in countries such as Turkey, Russia’s military adventurism in Ukraine, and weak economic data from China, finished the quarter only slightly down.

Q12014 Asset Classes

Despite the continued US stock market gains in the first quarter, the economic optimism that fueled last year’s stock market surge showed signs of fading. Weak housing market data helped more defensive sectors such a utilities and health care outperform the broader market.

Q12014 Stock Sectors

The Russian stock market was pummeled in the first quarter as fears mounted that the country’s annexation of Crimea would crimp its economy and its ability to export natural resources. Russia’s troubles may have obscured a more important development, however: disappointing economic data in Japan and China led to a weak first quarter for Asian stocks.

Q12014 Countries

The outlook for the Chinese economy is likely to be one of the key drivers of financial markets for the rest of 2014. For years bearish analysts have been predicting a financial crisis in the world’s second-largest economy, and declining property prices in China could be the start of a broader collapse that finally validates these gloomy prognostications.

Yet so far the Chinese government has overseen a fairly orderly decline in the country’s economic growth rate, and it has the capacity to stimulate the economy if it fears that trouble in the real estate market is spreading. Success in containing the fallout from the economy’s slowing growth would provide a boost for stocks around the world, particularly in China itself where valuations are very low compared to other countries.