In retrospect, the decision made by MSCI Inc (MSCI) in early June to continue excluding China from its emerging markets stock indices looks like a brilliant one. Chinese stocks are down more than 30% since mid-June, and judging from the headlines there’s no end to the rout in sight.
Perhaps more important than the decision to steer clear of the Chinese stock market, however, is the reason why MSCI felt China still wasn’t quite the right fit for its emerging markets indices.
That rationale has since been validated — in spades — by the way the state’s regulators have been completely unable to tame the beast they created.
Thing is, it’s not as if other emerging markets don’t pose a similar risk to its investors.
China was just the biggest.
Welcome to Emerging Markets!
While it wasn’t MSCI’s goal to sidestep the meltdown of Chinese stocks — the meltdown merely underscored one of the often overlooked problems with too many emerging markets. That is, the state loves free-market capitalism when things are good and stocks are soaring. That same state, however, exerts strict and even stifling authority when things are slow and stocks are crashing.
It’s called having your cake and eating it too. Unfortunately, just like anywhere else and anything else, it’s simply not possible.
To be fair, all nations (including free market nations like the U.S.) are subject to various degrees of state control. For instance, our Federal Reserve throttles or brakes the economy by tweaking interest rates. Our legislative bodies spur or stifle the economy by changing tax laws. It’s largely a passive control, though. To this day, the federal and state governments aim to take minimal roles in the turning of the economic engine.
This isn’t the case for emerging markets such as China, Russia, much of South America and most of Africa, however. Many of these economies function primarily to support the state’s government.
It’s a recipe for problems sooner or later, in that if a government has reason and opportunity to solve short-term problems by propping up its equity market, it will likely do so despite the adverse long-term impact that action may have. It’s just human nature.
This is largely what happened in China last year. Interest rates were lowered then in hopes that companies would borrow to expand. Generous margin loans were offered to draw new investors to the capital markets. IPOs were approved to capitalize on the combination of low interest rates and a swath of new investors looking for stocks to invest in.
There was just one problem: None of those maneuvers actually did much to spur earnings growth or stronger per-capita GDP. The stage was set by the government, but the actors never showed up.
Investors finally figured this out last month, almost a year too late.
While the debacle could superficially be chalked up to failed economic policy, there’s more to it than that. The state and its usual mouthpieces were indeed talking the stock market up.
Take these comments made during a speech from Adding Investment fund manager Wang Weidong, given just a few weeks ago to a crowd of enthusiastic investors:
“The 4,000 level (for the Shanghai Composite Index) was only the beginning of the bull market. They say the world is too big and I need to go and take a look. I would say, the stock market is hot, so how can I leave it behind?”
The Shanghai Composite Index now stands at 3,507.
Again, while China may be the highest-profile name in the emerging markets pool, its potential for manipulation, a lack of transparency and ever-changing rules (such as the sudden and still-unexplained trade halt on 40% of Chinese stocks) is a risk investors run with any emerging market.
And it’s perhaps that last concern (those changing rules) that’s the most pressing.
Could China or the leaders of other emerging markets ever simply limit or completely freeze the withdrawal of foreign capital? Never say never. A lack of this assurance was one of the key worries voiced by MSCI’s clients, and a likely reason as to why China wasn’t included in MSCI’s emerging-markets indices last month.
Given how quickly China’s regulators have become desperate to stop the bleeding, an appropriation or a lock-up of foreign capital can’t be ruled out no matter how extreme it seems. And even a lighter-handed decision could still be devastating.
As for Chinese Stocks …
As for China, while Wednesday’s headlines like “China’s stock-market crash is just beginning” are terrifying, that surge in doubt and pessimism may well be a sign that Chinese stocks are nearing a bottom … at least in the near-term.
In all seriousness, the market seems to work at vexing most of the people as much as possible. At this point in time — three weeks into the implosion of Chinese stocks — most investors are quite convinced China’s market is headed for a crash landing. Spikes in fear levels like this one tend to coincide with major bottoms.
The X-factor in the case of Chinese stocks is that 40% of them are currently halted from trading. It’s entirely possible these 1,300 stocks, give or take, will be sold indiscriminately once their trading resumes whenever it resumes. But, it’s also entirely possible the panic will have subsided by the time those Chinese stocks resume trading, minimizing the bearish impact they’ve yet to make on the broad market.
All the same, while the context for a bounce is there, tread lightly. It’s still a state-run economy, and loaded with state-owned or state-run companies.
As of this writing, James Brumley did not hold a position in any of the aforementioned securities.
