MACROSCOPE
Macroscope
by

China market rout, Grexit shows troubling market complacency

PUBLISHED : Thursday, 09 July, 2015, 8:15am
UPDATED : Thursday, 09 July, 2015, 8:15am

The complacency in global financial markets seems to know no bounds.

In the last month or so, China’s two main stock market indices have both dropped by more than a third in the sharpest sell-off since 1992 while Greeks have voted overwhelmingly to reject the demands of their country’s creditors, significantly increasing the odds that Greece will eventually be forced out of the eurozone.

Yet international investors have taken both of these headline-grabbing developments in their stride.

The benchmark US S&P 500 equity index has barely budged over the past month while the Vix Index - Wall Street’s so-called “fear gauge” - currently stands at 18.6, up from 15 a month ago but nowhere near the 60-70 range just after Lehman Brothers went bankrupt in September 2008.

Moreover, the yields on Spanish and Italian 10-year bonds - which were treated as reliable indicators of investor nervousness during the height of the eurozone crisis in the spring of 2012 - currently stand at just 2.2 per cent, compared with the 6-7 per cent range in June 2012 when financial contagion from Greece fuelled concerns about the possible break-up of the eurozone.

Why are investors relatively insouciant about China’s equity market rout and the threat of a Grexit?

There are a number of reasons, some of them technical, others psychological.

In the case of China, the idiosyncratic ownership structure of the Shanghai and Shenzen equity indices limits the fallout in global markets. Retail investors account for some 85 per cent of stock market turnover in China, in stark contrast to other large emerging markets (EMs) where institutional investors - both domestic and foreign - account for the bulk of the trade, significantly increasing the scope for financial contagion.

Just as importantly, the steep declines in Chinese stocks follow a dramatic and unsustainable surge in the two main indices which hit a seven-year high in mid-June. Even after the routs suffered over the past month, the Shanghai index is still up 8.5 per cent this year while the tech-heavy Shenzen index is up by a third.

As for Greece, investors appear to be buying into the argument that Greece is “different” and that if a Grexit were to occur the European Central Bank (ECB) would throw everything but the kitchen sink at the rest of so-called periphery of the eurozone - in particular Spain and Italy - to minimise the fallout.

Another possible reason for the relatively muted reaction of markets is that investors have become increasingly upbeat about the prospects for growth in the eurozone whose economies have, for the time being, proved fairly resilient to the Greek crisis. JP Morgan notes that “if the financial market response to a [Grexit] is more modest, then the hit to [economic] sentiment may also be more contained.”

Yet investors would be well advised to pay more attention to the underlying vulnerabilities and weaknesses which China’s stock market rout and Grexit risk have exposed.

In China’s case, the rout itself is far less troubling than the government’s conspicuous failure to stem it.

The raft of measures taken by Beijing over the past month - and particularly in the last several days - to stabilise the country’s plunging equity market have smacked of panic and are undermining the credibility of Chinese regulators at a time when the country’s economy is slowing sharply and when the Communist party is in the process of liberalising China’s financial sector.

The risk is that the reputational damage incurred by the equity market sell-off undermines the cause of Chinese capital market reform and, more worryingly, erodes confidence in the ability of the authorities to manage the economic downturn.

The Greek crisis, meanwhile, is a symptom of wider governance failures in Europe’s single currency area.

Not only have the structural flaws of monetary union been glaringly revealed - the currency union is being undermined by the absence of a political and fiscal union - it is becoming increasingly apparent that it is extremely difficult for a member of the eurozone to leave the bloc.

Instead of Grexit, there could be “Grimbo”: a Greece-in-limbo situation in which the country enters a legal twilight zone with its own parallel currency yet is officially still a member of the eurozone, resulting in a protracted state of crisis.

Seen in this light, the complacency in the markets is even more troubling.

 

Nicholas Spiro is managing director of Spiro Sovereign Strategy