Markets Fixate on Chinese Economy and The Federal Reserve

The volatility that engulfed currencies, commodities and stock markets around the globe in August has continued into September. Spikes in volatility are a normal part of the markets but we want to keep you updated on the reasons behind these spikes. In this case there are two primary causes of the increased volatility. Let's take a look:

1) The continued unease over the economic slowdown in China. 

Since 2010 China has been responsible for almost half of worldwide economic growth. China's growth filled a void created by abysmal growth in Japan and Europe, as well as the sluggish growth we have seen here in the United States. When diving into China's economic data, a fact that jumps out is total Chinese debt has grown from $7 trillion in 2007 to over $28 trillion as of mid-2014.

This increase in debt puts China's total debt/GDP ratio at almost 300% of annual GDP. The only country with a higher ratio is Japan. Japanese growth has been anemic for several decades, weighed down by their debt-load. Back to China- so much of their growth in the past seven years has been thanks to an almost unprecedented credit boom. Due to China's tight capital controls most of this debt is held within China. Earlier this summer BlackRock Investments summed up the problem:

“China has been taking on increasing amounts of debt to maintain growth. Yet it has been getting less bang for its yuan as growth has edged down. Credit growth is not just losing its potency; it is turning into a poison. Debt is growing faster than borrowers’ ability to service it. The resulting debt mountain stood at $28.2 trillion at the end of 2014, according to a McKinsey report. The debt cannot be rolled over indefinitely. China’s debt-to-GDP ratio has reached almost 300%. Government debt makes up a relatively small share of the total, with the bulk in the corporate sector”.

For the past thirty-five years China's GDP growth has averaged almost 10%. However, China's per capita GDP is only $7,572. As a comparison, the per capita GDP in the U.S. is $54,678. What that means is that China needs many more years of high growth in order for prosperity to continue increasing. China's ruling party is the Communist Party and they know strong economic growth is critical to their stability as a ruling party. In recent months we have seen signs of panic from the Chinese government like devaluing their currency, cutting interest rates for the fifth time since December 2014, spending over $500 billion to try and prop up stock prices (something that hasn't worked) and now arresting over 200 people for alleged rumor-mongering related to sharp decline in stocks.

Just because China has $28 trillion in debt does not mean a crisis has to develop, look no further than Japan for proof of that. Also, we are not saying that the Chinese growth story is coming to an end. But if China tries to deleverage and not rely so heavily on debt for new spending what will that do to global economic growth? The China story is going to be very interesting to watch in the coming months and years.  

2) Speculation and debate about whether the Federal Reserve will or will not raise interest rates at their September meeting. 

The Fed has kept interest rates at near-zero since the 2008 crisis. While the decision to lower rates to zero was a wise one at the time we believe the Fed has made a mistake by waiting this long to have their first rate increase. The U.S. economy is at a point where it can clearly handle a .25% increase in rates. While 2.2% GDP growth in the first-half of the year does not make for a thriving economy certainly current conditions such as fifteen-year lows in jobless claimsa strengthening housing market, an uptick in business investment and strong corporate balance sheets illustrate that the economy is not on life support and can handle higher interest rates. Now to be clear we are not talking about the Fed normalizing interest rates. If the Fed were to raise rates by .25% in September and another .25% in December, rates would still be less than 1%, a figure that is still extremely accommodating. 

The Fed's easy-money policies since 2008 have been a boost to asset prices, including real estate and stock prices. It is no surprise that as we get closer to the Fed potentially increasing rates that market volatility has picked up. Once the Fed begins to raise rates there is no question that the pace of increases will be extremely slow. But the market will still have to adjust to the fact that rates will be going higher. As of today the market puts the likelihood of the Fed raising rates on Sept 17th at 27%. Put us in the camp hoping the Fed does move forward with raising rates this month, just the fact that they get the first increase out of the way could help calm the markets.

In the near-term we expect that economic news out of China will continue to be heavily scrutinized as global markets try to digest developments in the world's second-largest economy. Here in the United States, the Fed will have to decide if the recent turmoil in China is going to push back the first rate increase or if stronger U.S. economic data gives them the cover to move rates higher. The world will be closely watching.