How China Affects the U.S. Stock Market

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The Chinese economy has become a focal point for investors, analysts and policy makers around the world. Underestimating the importance of China on the global financial stage would be a huge mistake.

How China Affects the U.S. Stock Market

Source: ©iStock.com/MarcoCoda

However, overestimating the importance of China on most individual stocks within the U.S. stock market would also be a big mistake.

To understand the difference, we are going to take a look at the Chinese economy and its impact on the following:

  • Monetary policy
  • Commodity prices
  • Individual stocks

Let’s start with a broad look at how China is impacting the Fed.

China’s Impact on Monetary Policy

If you’ve been reading the financial news for the past few years, you know that traders everywhere are hanging on every word that comes from the Federal Open Market Committee (FOMC). The FOMC’s decision to lower rates to 0% in 2008 and engage in various quantitative-easing programs from 2008 through 2014 sent stocks soaring higher. Now, expectations regarding when the FOMC is going to achieve “liftoff” by raising rates from 0% has the market tied up in knots.

Typically, China would not come into the equation for the FOMC as it decides what to do with interest rates. However, that seems to have changed.

In its latest monetary policy statement, the FOMC added the following four bolded words (emphasis added):

“The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced but is monitoring developments abroad … This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.”

Most investors believe these “international developments” refer to the People’s Bank of China’s (PBOC) manipulation of the yuan and the extreme volatility we’ve seen in the Chinese stock market — both of which have made investors skittish.

As you can see in Fig. 1, the value of the yuan compared to the U.S. dollar (USD) had been rising steadily since 2010. The exchange rate seemed to have normalized and was consolidating through 2014 and the early part of 2015 when, on Aug. 10, the PBOC suddenly cut the value of the yuan by 1.9% — the biggest one-day cut since 1994.

slingshot-china-1Fig. 1 — Daily Chart of Yuan /U.S. Dollar Exchange Rate (courtesy of Trading View)

This rate cut shows that the Chinese government is concerned about its slowing economy (more on that later) and was feeling increased pressure from investors to adjust its currency peg lower.

As if this weren’t enough to worry investors and policy-makers, this rate cut occurred right after the Chinese stock-market bubble burst. As you can see in Fig. 2, the Shanghai Class-A stock index exploded higher in late 2014 and early 2015, only to crash back down in June and early July.

slingshot-china-2Fig. 2 — Daily Shanghai Class-A Index Chart (courtesy of TradingView.com)

Knowing that the surprise change in monetary policy from the PBOC and the volatility in the Chinese stock market would lead to further uncertainty in the global financial markets, the FOMC decided to hold off on raising interest rates at its September meeting in hopes of finding a less volatile market environment in which it could raise rates.

The FOMC meets again from Oct. 27 to Oct. 28, but, according to the CME Group FedWatch, traders of federal funds futures contracts are only putting the probability of a rate hike at 5% in October (see Fig. 3).

slingshot-china-3Fig. 3 — CME Group FedWatch Rate Expectations for October FOMC Meeting

The last FOMC meeting of the year takes place from Dec. 15 to Dec. 16, but the probability of a rate hike at even that meeting is only 30% (see Fig. 4).

slingshot-china-4Fig. 4 — CME Group FedWatch Rate Expectations for December FOMC Meeting

Until the value of the yuan and the Chinese stock market can stabilize, the FOMC is going to have to continue to weigh the potential negative impact that a rate hike could have on the U.S. stock market in these already turbulent times.

China’s Impact on Commodity Prices

The slowdown in the Chinese economy and the increase in the value of the USD have been the two primary factors that have driven commodity prices lower during the past year.

To put things in perspective, according to the International Monetary Fund (IMF) World Economic Outlook, China has the second-largest economy as measured by gross domestic product in U.S. dollar terms (see Fig. 5).

slingshot-china-5Fig. 5 — GDP Comparison, Current Prices (courtesy of Knoema)

However, when you look at GDP using a purchasing power parity (PPP) valuation — a more accurate reflection of influence of the economy on the global stage — China is actually the largest economy (see Fig. 6).

slingshot-china-6Fig. 6 — GDP Comparison, Purchasing Power Parity Valuation (courtesy of Knoema)

China is not only the largest economy in the world but also the largest importer of many commodities — like copper, iron ore and oil. So when the Chinese economy starts to slow down, demand for these commodities slows.

We’ve been seeing many signs of an economic slowdown in China. After rebounding in 2009, thanks to a massive amount of government spending, Chinese GDP has slowed to 7% (see Fig. 7).

slingshot-china-7Fig. 7 — Chinese GDP (courtesy of Forex Factory)

While 7% growth may seem like an amazing growth rate in the United States, it is quite slow for China, and many wonder if this number isn’t artificially inflated to meet the goal of 7% GDP growth that the Chinese government set in March.

A large part of the decline in GDP has been a decline in Chinese industrial production. As you can see in Fig. 8, industrial production levels have been declining since early 2010 and are currently near their post-financial-crisis lows.

slingshot-china-8Fig. 8 — Chinese Industrial Production (courtesy of Forex Factory)

The troubling thing is that it doesn’t look like this slowdown is going to let up anytime soon.

According to the Caixin Manufacturing Purchasing Managers’ Index (PMI), the outlook for increased production is negative. The Caixin Manufacturing PMI is a diffusion index. This means that any number greater than 50 indicates expansion, while any number less than 50 indicates contraction. The further away from 50 the index gets, the stronger the expansion/contraction reading becomes.

As you can see in Fig. 9, the Caixin Manufacturing PMI has been below 50 since March, and it is getting progressively lower.

slingshot-china-9Fig. 9 — Caixin Manufacturing PMI (courtesy of Forex Factory)

Its current level of 47.2 is actually the lowest level since the 2008 financial crisis.

This slowdown in the Chinese economy, which looks like it will be with us for a while, and the subsequent decline in the value of commodities due to decreased demand, are important in a couple of ways.

First, lower commodity prices have a deflationary impact on both producer and consumer prices. One of the criticisms the FOMC has come under regarding its plans to raise rates is the fact that inflation isn’t currently a problem. Many are asking, if inflation isn’t rising, why raise rates?

Second, lower commodity prices tend to have a negative impact on commodity producers and a positive impact on commodity consumers. For example, mining stocks have been hammered as the price of copper, gold and other metals has dropped, while copper-wire producers and others have benefited from the decline. Similarly, oil producers have been hit hard by falling oil prices, while airlines and others have benefited from the cost cut.

This leads us into our discussion on the impact China can have on individual stocks.

China’s Impact on Individual Stocks

When it comes to individual companies that actually have a large amount of revenue exposure to China, the list is surprisingly small.

According to Goldman Sachs, only one of the S&P 500 sectors — Information Technology — has more than 2% revenue exposure to China (see Fig. 10).

slingshot-china-10Fig. 10 — S&P 500 Sector Revenue Exposure to China (courtesy of Bloomberg)

The S&P 500 itself only has 2% revenue exposure to China.

Of course, there are a few individual companies that have a massive amount of Chinese revenue exposure, but, as you might expect, most of them are in the Information Technology sector.

As you can see in Fig. 11, Skyworks Solutions (SWKS) has the largest amount of exposure at 83%, but companies from other sectors also have exposure, such as Wynn Resorts (WYNN) and YUM! Brands (YUM) from the Consumer Discretionary sector with 70% and 52% exposure, respectively.

slingshot-china-11Fig. 11 — S&P 500 Stocks Revenue Exposure to China (courtesy of Bloomberg)

This tells us that while we definitely need to watch the larger macroeconomic trends that are being affected by China and the impact they may have on the stock market in general, we need to analyze each company individually before we get too nervous that slowing demand in China is going to have a dramatic impact on a stock’s price.

We are going to be getting updated GDP and Industrial Production data from China this weekend. We will be watching to see if there are any trend changes in the data and how Wall Street reacts to the news.

We anticipate that the data will remain weak, which should continue to put pressure on the FOMC to leave rates unchanged and allow the S&P 500 to remain above its late-August lows.

You can learn more about identifying price patterns and using them to project how far you think a stock is going to move in our Advanced Technical Analysis Program.

InvestorPlace advisers John Jagerson and S. Wade Hansen, both Chartered Market Technician (CMT) designees, are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next SlingShot Trader trade and get 1 free month today by clicking here.

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