China’s stock market is about to collapse

June 20, 2015

It’s been an ugly week for Chinese equities, but today’s performance is a whole other level of ugly:

Today marked the fourth largest decline of the Shanghai Composite in two decades.

We’ve discussed the insane valuations on the Shanghai and Shenzen stock-exchange before. As our regular readers will know, today’s fireworks have been a long time in the making.

Today the benchmark Shanghai Composite plunged 6.4%.  That brings the carnage for the week to a total of 13.3%.

Next stop?

All major stock-market reversals are worthy of attention:  But this is different.

This is the world’s second largest economy, and it’s a house of cards.

China is primed for collapse

Let’s take a step back and take a look at how dire the situation is for China, and why China’s situation has important ramifications for the world.

By last summer, China’s central planners had become extremely concerned that their real estate bubble was looking increasingly ominous. Housing prices had clearly stalled.  Construction had dropped rapidly. Defaults were rising. And China’s GDP was plunging to levels not seen in 25 years.

Around that time China’s banking insiders were also beginning to whisper about the size of China’s shadow-banking system, and whether or not a complete collapse of China’s banks could be looming on the horizon.

For all the talk of the “China miracle”, it had become obvious in 2014 that the party was over.

In a terrifying case of “what could possibly go wrong”, China’s economic mandarins ordered China’s central bank to drop interest rates, and spew billions of dollars worth of liquidity into the economy.   Making matters even scarier:  The PBOC allowed China’s banks to leverage up, and decrease banking reserve ratios.

On the political front, China’s supreme leader, Xi Jinping pushed for intellectually bereft economic policies designed to keep the party going at all costs.   The Shanghai Composite rose like a rocket, soaring 125% in under a year, while brokerages saw their margin loans explode 500% to a terrifying 2 trillion yuan.

Today’s China Ponzi

Today, China’s markets are a Ponzi scheme of historic proportions.  If they collapse, the blast radius will engulf the world’s financial markets.

The Hong Kong stock exchange for example, has risen handsomely on the back of capital flooding in from the mainland.  A collapse in Shanghai and Shenzen will have immediate implications for Hong Kong, and on world markets by proxy. Consider also, that millions of Chinese investors borrow against their home-equity to invest in the stock market.  The irony here is that the stock bubble which Beijing manufactured to offset their collapsing real-estate bubble, could end up being the catalyst for the collapse of housing prices.

Perhaps scariest of all, is the great unknown of China’s unregulated shadow banking system, which has no oversight or margin requirements to speak of.    Shadow banks have negligible capital reserves. Their non-existent regulatory requirements have allowed the sector to take on near suicidal levels of leverage, which in a rising market has powerfully distorted growth to the upside.  Unfortunately for China’s shadow banks, that sword cuts both ways.   As credit markets tighten, the risk of catastrophic losses becomes more probable.

As of today, there are no indications that this move has run out of steam to the downside.  But we have little doubt that there are panicked plans being scrapped together in China’s halls of power at this very moment.  Needless to say, they won’t work.   If governments could simply decree economic success over the long term, we would all be speaking Latin.

Did the China bubble just pop?  We think it’s highly possible.  But we have no doubt that “emergency measures” will be attempted.

Global Risks

There are risks here too for global investors:  Global emerging market funds are heavily weighted towards China.  And China’s equity market implosion seems to have arrived at exactly the moment when US equity markets are overvalued and highly uncertain.  Add the risk of a Greek exit to the global equation, and the larger picture of a global financial rout cannot be dismissed.

We would call China’s swooning markets a “black swan” event, but the truth is there are multiple black swans circling overhead:  Greece alone has the ability to send the Eurozone into a tailspin.  Back in the US, technology stocks are seriously overvalued and running on little more than promises.   Meanwhile rest of the world seems to be making a habit of lowering GDP expectations with each successive quarter.

We have no doubt that Xi Jinping will push the PBOC to pull another miracle out it’s hat.   But when we see leverage at these levels, combined with anemic oversight, there’s little doubt in our minds:  A China implosion is coming.   And it might be here already.  This bears watching closely.