Steep falls in global stock markets over the past few weeks have raised fears that escalating international trade conflict could trigger an October crash reminiscent of those in 1929, 1987 and 2008, when the United States’ equity market plunged by 25 per cent in a matter of days. But while the risk of an even steeper sell-off cannot be dismissed entirely, the US-China trade war will not be to blame.
All through this summer, American investors and businesspeople were confident the US would emerge the victor in its trade war with China. As evidence their optimism was justified, many pointed to the relative performance of the US and Chinese stock markets. In the six months or so after US President Donald Trump first ordered officials to impose import tariffs on goods from China, US stock prices rose by 10 per cent.
Over the same period, the broad Chinese market fell 15 per cent. And the Shenzhen A-share market, which better represents the sort of private-sector exporters and technology companies likely to be most affected by US tariffs, slumped 20 per cent.
This marked divergence, argued many American investors, reflected the relative strength of the US economy, and the fragility of Chinese corporate earnings and growth in the face of US tariffs.
Over the last month, their confidence has taken a severe knock. Since the beginning of October the benchmark US S&P 500 index has slumped by 7.5 per cent, roughly in line with the fall over the same period in the Chinese stock market. This suggests investors may be beginning to conclude that the US economy is also vulnerable to trade-war escalation.
Except for one thing: the idea that the divergence over the summer between US and Chinese stock prices was driven by relative hopes and fears about trade never looked very convincing. There is a far simpler explanation – instead, markets in each country have been propelled primarily by domestic drivers.
In the US, the stock market run-up between late March and the end of September was powered mainly by the positive impact on corporate earnings growth of the US government’s late-2017 tax cuts.
And this month’s sell-off was triggered by the rise in early October of long-term interest rates, in the form of US Treasury note yields, to their highest level since early 2011. This increase emphasised how elderly the current US business cycle now is, and how, with the one-off boost from tax cuts about to disappear, the labour market tight and wage pressures rising, earnings growth at US companies is far more likely to slow than accelerate over the coming quarters.
In China, of course, the stock market has been falling for months. But it is hard to claim that trade-war fears are the main cause of the slide. For one thing, China’s exporters are not yet feeling the pinch. Since the first mass US tariffs went into effect in early July, Chinese export growth has actually accelerated, rising to 14.5 per cent year on year in September. Moreover, most exporters at this month’s Canton trade fair reported full order books and production lines at maximum capacity.
That makes sense. Since the US’ late March announcement that it would go ahead with tariffs, the yuan has fallen 10 per cent in value against the US dollar.
This is exactly what economists expect to happen. When one country with a floating currency imposes tariffs on another, making its goods more expensive, the bilateral exchange rate adjusts to compensate for the loss of competitiveness.
Admittedly, China’s exchange rate regime is a managed float, rather than a free float. But while in recent months the authorities have not intervened in the foreign exchange market to push the yuan lower, neither have they stepped in to prevent its fall.
As a result, the yuan’s weakness against the US dollar allowed Chinese exporters hit by US tariffs to absorb the additional cost into their US dollar pricing, without any negative impact on their yuan earnings. And exporters not yet affected by US tariffs enjoyed an earnings boost.
In short, US tariffs already in place and those threatened at the end of the year have largely been priced in by the currency market, with the yuan’s exchange rate bearing the adjustment rather than Chinese corporate earnings and the Chinese stock market.
So if it’s not the trade war that’s beating down Chinese equity prices, what is it? The main culprit is Beijing’s campaign to crack down on China’s shadow financial system, and the build-up of excessive leverage that system had encouraged.
As the campaign brought financing out of the shadows and back onto the balance sheets of state banks, bank executives reverted to their former practice of lending only to low-risk state-linked borrowers.
This squeezed the funds available to private companies. In response, company founders took to pledging their own shareholdings as collateral for working-capital loans, raising much-needed liquidity.
But the problem was that as the stock market began to soften, participants became increasingly worried about the decline in value of the pledged collateral. Further falls could leave the owners of pledged shares facing margin calls they would be unable to meet, which in turn could lead them to make forced sales into a falling market in what could rapidly turn into a death spiral.
As of mid-October, it was estimated that some 2 per cent of the mainland’s stock market capitalisation was at risk of forced sales – a proportion that could increase rapidly should prices fall further.
The danger was great enough to prompt the authorities to step in last week, with local governments, brokerage companies and state enterprises and state-backed investment funds all putting up cash to support companies with high ratios of pledged shares.
Whether that effort will be successful remains to be seen. Chinese share prices initially jumped on the move, before giving back much of their gains later in the week.
But the lesson is clear: the falls in US and Chinese stock markets – the world’s two largest by capitalisation – have been driven primarily by idiosyncratic domestic factors. Things could still get worse, but October’s slide in markets is not the beginning of a new global crash triggered by Donald Trump’s trade war. ■
Tom Holland is a former SCMP staffer who has been writing about Asian affairs for more than 25 years