Everyone Please Remain Calm-It Was Just a Correction

If last week taught us anything, it is that many of the world's most liquid mature equity markets have started taking cues from China, be it justified or not. Previously, the vast majority of people agreed that, given China's unquenchable hunger for resources, China was a significant player in determining world commodity prices (i.e. steel, oil). People also largely agreed that China was in many ways responsible for holding US interest rates down due to their feverish purchasing of US Treasury Bills. Yes, those of you in the US that took advantage of the low interest rates and refinanced your homes in the past few years, you have China to thank whether you want to admit it or not. China's buying of US T-bills has less to do with their attractive investment returns and more to do with keeping their own currency weak relative to the US dollar enabling their export engine to keep running. Keeping US interest rates low is in China's interest, because it keeps US consumers purchasing goods that China exports. Continued export customers keeps China's factories humming and employment up, something critically important in a country that must maintain over 7% economic growth annually to create enough jobs for new people entering the work force annually.

There has been chatter that China, in addition to many other nations (i.e. cash rich Middle-Eastern countries-->price of oil per barrel is denominated in US$), are looking to diversify their FX holdings into other currencies and/or gold. Currently, China holds over $1 trillion in US T-bills. No, that is not a typo. If I'm a market speculator, I'm definitely betting that gold is going up. The economics just make sense. If these countries do indeed choose to dump a percentage of their USD holdings in favor of other currency's or gold, expect US interest rates to jump and money not to come quite so cheap in the US. Adios, to the low financing of the new car.

The events of this past week warrant some consideration. We must ask ourselves, how does an 8% drop in a stock market (China's A-share market) that was among the world's worst performers in 2004 and 2005 and is coming off a year during which it increased 130% send such shock waves throughout the world? The following day, the Dow was driven down almost 4% and other indicies around the world took it on the chin as well for no real reason at all. After a 100+% rise in the China A-share market over 12 months, isn't a slight pull back justifiable, even expected?

Before 2006, the rest of the world didn't care what was happening on China's stock market. It was what many considered to be a casino. Maybe this is what was necessary for people to finally take notice or acknowledge that they already knew subconsicously. Officials have openly stated this year that over 70% of the listed stocks on China's A-share market are worthless and should be delisted. Granted, things are getting better, regulations are beginning to be enforced and more quality companies are starting to list in mainland China, but China's financial infrastructure has a long way to go. A country might be able to build highways and bridges in 20 years, but instilling the concepts of intrinsic value, corporate governance and regulatory enforcement take time no only to implement but to educate people as to why they are necessary for a well-functioning market.

My guess is, this won't be the last "pullback" China's market experiences. I believe there were actually people in China breathing a sigh of relief as the government has been working very hard to find ways to cool the already overheated market. The question is, how will the world react when it happens again, and believe me, it will. That is the nature of an emerging market.

I think we should stop pondering whether or not there is a connection between China's equity markets and the rest of the world or if the aftershocks are justified. Rather, it would be better to accept the fact there is a perception of a connection ingrained in peoples' minds. As one of my coworkers accurately stated, "fear and greed" drive the market. In the end, I think most people think there shouldn't really be a correlation between what happens on China's markets and the rest of the world, however, they "fear" there just might be, and that is enough to cause a panic.