How Chinese Economic Weakness Brings Down Global, US Markets

12/17/2018 3:33 pm EST

Focus: MARKETS

Don Kaufman

Co-Founder, TheoTrade

The elephant in the room that stops investors from buying stocks is uncertainty over trade and potential for a hawkish Fed. Unlike earnings multiples and future estimates, uncertainty isn’t easily quantifiable. And why I look at technical analysis & trader sentiment.

China’s growth has been slowing for years. It had a minor blip higher in 2017 but has weakened again this year. Its weakness is partially responsible for the negative GDP growth in Germany in Q3. China has had better reports because of front running.

Firms wanted to get ahead of the tariffs, so they did extra business before they were enacted. That ended in November as the latest metrics were terrible.

The chart below shows the long term downtrend in industrial production and retail activity growth. Industrial output was up 5.4% in November which missed estimates for 5.9% growth. This was the slowest growth rate since January to February 2016.

As I try to gauge the severity of the current global economic slowdown, the best comparison is the 2016 slowdown. Currently, the U.S. is not seeing as much weakness as it did in early 2016, but the rest of the world is coming close as you can see with these results from China.

chart 1

Retail sales growth was 8.1% in November which would be amazing for most countries, but not for China. This is the weakest growth rate since 2003 which isn’t included in the chart. Growth was expected to be 8.8% and was 8.6% in October. Analysts expected a slight improvement, but instead growth cratered.

I think China is seeing cyclical economic weakness which is amplifying the secular growth decline. China has bad demographics and a centrally planned economy which needs to become freer if it wants to get back to its previous run of high growth.

The final part of the report was the best as fixed asset investment growth rose from 5.7% to 5.9% which beat estimates for 5.8%. This still wasn’t a great figure as it was 7.9% in February. However, it is an improvement from 5.5% in August.

Weakness is good news for trade

China announced the weakness wasn’t related to tariffs, but it obviously was. If you don’t think tariffs played a role in this negative report, then you much be extremely bearish on China because the data will get even worse once tariffs are included. President Trump tweeted that China’s economy slowed because of the tariffs and that China wants to make a trade deal.

I think these weak numbers are good news for investors because they will further nudge Chinese leaders to make a deal. Capital markets are negatively reacting to these reports which should encourage policy makers to act.

Once a trade deal is made, stocks across the world will rally. That’s going to be a great opportunity to short stocks. Because of the possibility of a trade deal, this is becoming a great buying opportunity as investors are starting to price in the worst case scenario. If Chinese policy makers are planning a stimulus in 2019, they will make a deal. If they don’t, it is a self-inflicted wound.

Should the Fed raise rates?

The more stocks fall, the less likely the Fed will raise rates. The more commodity prices fall, the lower headline inflation will be, which could support dovishness. The Earnings Scout put out the chart below which shows the collapse in commodities prices. As of the December 14 close, the CRB Bloomberg Commodity ETF (COMD) is down 2.12% in the past year and 6.81% year to date.

This theory promoted by The Earnings Scout has become popular as members of the financial press and investors clamor for the Fed to save the market. However, I don’t think oil will crater in the next few months because there is an inventory deficit. If the dollar index falls, commodities could increase. This explains why the Fed doesn’t act based on headline inflation and the swings in oil prices.  

chart 2

Earnings estimates not falling off a cliff

The negative earnings revisions told us to be bearish on stocks in October. With stocks correcting lately, this prediction has been fruitful. Now let’s look at the latest estimate changes to determine how to trade stocks in mid-December. As you can see from the table below, the estimates continued to fall. Estimates for Q4 earnings growth on October 1st were 15.37%. They are now 11.27%. I have stated that it is possible earnings growth estimates can fall below 10%. If that occurs, earnings beats will likely end up pushing growth back into the double digits.

chart 3

The good news from this latest data is that the further into the future you go, the less estimates fell in the past week. Earnings estimates usually fall before earnings season because analysts start out too optimistic.

Estimates need to fall more than average for it to be negative. 2019 earnings estimate declines have fallen in line with the average decline. Since stocks are now falling, this average performance is bullish for stocks. If earnings growth in 2019 ends up in the mid-single digits, stocks won’t continue their latest decline in the first half of the year.

When to buy stocks

When traders are extremely bearish, it can give you the confidence you need to go against the tide. Skeptics of being bullish can say that earnings estimates will fall further. However, they can’t say sentiment is optimistic. Sentiment is horrendous.

Conclusion

The negative Chinese economic data sent stocks lower across the world. The good news from this is it means a trade deal in the near term is more likely as politicians don’t want to shoot themselves in the foot. This situation is different from when stocks rally on bad news because traders think the Fed will be dovish.

Firstly, stocks aren’t rallying.

Secondly, a trade deal is good news without any negative consequences. If the Fed is too dovish, it can boost inflation and create asset bubbles. It’s bad in the long term if the Fed stays dovish for too long.

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