03-02-07
I'll be a big noise, with all the big boys . . .
- Peter Gabriel, "Big Time"
Shanghai Surprise was originally a 1986 box office bomb starring Madonna and Sean Penn. In case you missed it, the movie was billed as "a romantic adventure for the dangerous at heart." It was nominated for five Golden Raspberry awards and took home the prize for Worst Picture.
More recently, a "Shanghai Surprise" is exactly what the markets got on February 27, 2007, when an 8.8% freefall in the Shanghai Composite Index touched off a domino chain of panic across the globe.
So is the carnage of the past week all China's fault? Not exactly.
As Barry Ritholtz has pointed out, the total capitalization of China's Shanghai and Shenzhen markets was a mere $1.4 trillion after Tuesday's drop, while the US equity markets (NYSE, NASD, AMEX) weigh in at a collective $27 to $28 trillion. (Picture a Shih Tzu sitting next to a Great Dane.)
Ritholtz concludes: "By my back-of-the-envelope calculations, our correction of 3.5% wiped out an estimated $1 trillion dollars in combined NYSE/NASDAQ 100 value—more than two thirds of the entire capitalization of both of China's exchanges combined."
In other words, on a pound-for-pound basis, Shanghai is still small fry.
There were plenty of other troubles brewing for US markets, anyway. Complacency reigned supreme, the major indices hadn't seen a real correction in six months or so, and the VIX (CBOE volatility index) had sunk lower than a melancholy earthworm's chin.
Nor did it help for ex-chairman Greenspan to mention the word "recession" to a Hong Kong audience one day prior to the meltdown . . . like a meddling uncle who just can't keep his mouth shut.
For all that qualification, though, the "Shanghai Surprise" was still a genuinely intriguing phenomenon. It underscores the fact that Asian markets have hit the big time—in psychological terms at least—and offers a useful reminder of just how interconnected global markets have become.
The aftermath of the event also speaks to the rapidity of China's rise—and the growing hunger of Asian investors. Consider this anecdote from the Wall Street Journal:
The morning after China's stocks had their biggest one-day plunge in a decade and triggered a global selloff of shares, Qiu Liming lined up with a dozen others to open her first trading account at a Shanghai brokerage firm.
"I'm ready to trade stocks," said the 54-year-old retiree, who had to use sharp elbows to retain her spot in line. "It has been developed for more than 10 years, so the market is inclined to maturity."
The picture accompanying the WSJ article shows a group of locals, mostly women, waiting on the sidewalk to open their new accounts. Once again, mind you, this is immediately after the big drop. No shrinking violets here.
Chinese investors certainly deserve credit for intestinal fortitude. They may be a little premature in their zest for bargains, though. Shanghai stocks are probably not good values just yet.
As Grant's Interest Rate Observer pointed out a few weeks ago, Shanghai buyers have routinely been paying huge premiums for dual-listed shares that are offered much more cheaply in Hong Kong. China Life Insurance Company, for example, at one point saw an 83% premium in its Shanghai "A shares" price relative to its Hong Kong "H shares" price.
This huge discrepancy exists only because of strict government capital controls. Beijing's rules, which prevent money from flowing freely in and out of China proper, also prevent arbitrage traders from doing their job. Think of beer and hot dogs at a baseball game; what might cost you $2 in the outside world can run as much as $9 inside the stadium. Demand is high, the audience is captive, and there is no place else to go.
The Chinese government will eventually be forced to scrap its capital controls, if only to keep inflation from running wild as export dollars flood the banks and investors lather themselves into a frenzy. (Roughly 82 million Chinese now have stock trading accounts. That's 5% of the population, or 1 out of 20.)
To borrow an old Greenspanism, Beijing is faced with a "conundrum": if China's currency is held down for too long, domestic markets will eventually boil over. But if controls are lifted too quickly, China's export growth could be compromised by the currency's sharp rise.
For an export-oriented economy, the challenge of a strong currency plus rising input costs has only one desirable solution: moving up the value chain. China is no longer satisfied churning out basketballs and sneakers; they know that Vietnam, Thailand, Bangladesh and others are nipping at their heels. China will have to move towards more sophisticated offerings—to "move up the value chain"—if it wants to maintain solid growth as competition improves and production costs rise.
And it appears they are getting it done. In a recent article titled "Chinese exports show boost in profits," the Financial Times reports:
Combined with investment in new technology, the dominance by Chinese firms of some industries may also be giving them more pricing power than previously thought.
The fastest growing export sectors in 2006 were aircraft parts, shipbuilding, integrated circuits, cars and car parts, electrical machinery and telecommunications equipment.
In sum, China seems to have a rapidly growing economy with a fair share of serious problems (choking pollution, capital controls, widespread corruption, looming energy issues) but a fair share of real successes too (budding capital markets, eager investors, strong industrial development, rising domestic demand).
Against that backdrop, the existence of a "Shanghai Surprise" or two should be no surprise at all as China moves forward. It is easy to forget just how rough-and-tumble markets can be, especially in the early stages of development. There are plenty more mistakes for China to make along the way, some of them quite bad. But chances are those mistakes will be more like potholes than permanent setbacks.
As Jim Rogers reminded his audience at the New Orleans 2006 investment conference, the United States basically went bust in the panic of 1907. After that little misstep, of course, the US went on to completely dominate the twentieth century. Rogers's point was that a dynamic economy like China's could endure serious turbulence along the way—even a full-scale financial collapse like the one America saw a hundred years ago—and still achieve its goal of becoming a great economic power.
So, does this mean we should we all rush out and buy shares in FXI and PGJ—two popular China ETFs—and emulate those brave Shanghai investors lining up on the sidewalk?
Not quite.
Marc Faber, legendary Hong Kong money manager and editor of the Gloom Boom & Doom Report, thinks now is not the time to step into emerging markets. "I wouldn't buy," he says. "Something has changed in the financial market: it's the time to sell the rallies rather than buy dips."
From a trading perspective, we find it hard to disagree with Mr Faber. All the emerging market ETFs—and all the major market indices for that matter—have the look of a man who has just fallen down six flights of stairs. When you take a fall like that, you don't dust yourself off and get back to humming show tunes right away. Mending time is required.
But with that said, it would be a mistake to underestimate how much the world is changing . . . and how quickly that change is taking place. An excellent book for gaining perspective on this is The Emerging Markets Century by Antoine van Agtmael. (Agtmael is the man who literally coined the phrase "emerging markets"—which sounds a lot better than "third world markets," the going phrase at the time.) The subtitle of Agtmael's book gives the flavor of its contents: How a New Breed of World-Class Companies is Overtaking the World.
Your humble Macro Musings editor is neutral on emerging markets in the short to medium term. But in the long term, he is bullish indeed . . . and will be watching closely for the all-clear sign on the buy side. Much the same goes for energy, metals and grains—but we'll hold those thoughts for another day.
