An economist's view of the Chinese selldown

BT Funds' chief economist Chris Caton provides some thoughts on the recent selldown of equities.

Tuesday, March 6th 2007, 6:48AM

We live in interesting times. Speaking in Adelaide on Tuesday, I told audiences that, unless something major happened in the following two nights, the Dow would record its ninth successive monthly rise, which had apparently never happened before. It still hasn’t.

I also told my audiences that there was an eerie silence out there following the rise in Japanese rates the week before, and I reminded them that policy tightening by Japan and other central banks early last year was a big contributor to the (eventual) equity sell-off in May 2006.

The night after I spoke, the US share market fell by more than 3%, with inevitable consequences for the Australian market the next day.

Let’s be clear - equity markets have been overvalued for some time. The overvaluation reflected too great an appetite for risk (or possibly too little understanding of risk!) on the part of investors. Overvalued markets can remain that way for a long time, but they are always vulnerable to correction.

In this case, the catalyst was in an unlikely place: China. The Shanghai market fell by 9% on Tuesday, and this fall then reverberated around the world. It is important to point out that the drop had very little to do with any change in fortune for the Chinese economy.

The Chinese domestic share market has had a very strong run lately, and was clearly vulnerable. The fall in China seems to have come about as a result of rumours that the Government was going to act to cut down on speculation and ‘illegal’ investing. The only salient news on the economic front was a rather heavy CPI figure.

It is also important to note that, like most developing economies, the links between the share market and the economy are not strong, so the fall in the Chinese share market (40% of which was reversed the next day) should have very little effect on the Chinese economy, and hence little or no effect on the demand for commodities, for example.

The knock-on effects on the US market were exacerbated by some simultaneous economic news (durable goods orders for January) that suggested increasing weakness in the US manufacturing sector.

I continue to think that the consensus forecast that the US economy will experience nothing more than a ‘soft landing’ this year may yet prove too optimistic. This may be the biggest ongoing risk to share markets.

Is the current episode effectively over? It would be optimistic to say yes. Markets are certainly likely to remain volatile for some time. On the scale of recent ‘pullbacks’, this has so far been a very small one.

History teaches us that such ‘pullbacks’ are almost always buying opportunities. Corrections of 5-10% occur regularly in rising markets, and investors who simply do nothing are generally back above where they were the day before the correction within weeks.

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