The Danger in the Chinese Market

The benchmark Shanghai Composite Index (SCI) broke to a record high of 6,124.04 on October 16, but has failed to hold above 6,000 in subsequent sessions. The SCI fell about 11% in a multiple-day correction to an intraday low of 5,462.01 on October 26, but whether this is an indication of a top is too early to call.

 What we do know is that the recent momentum was out of hand, with the SCI near overbought territory. The rapid rise of the SCI this year gives it bubble-like characteristics, as the market there appears overextended. Speculation and frenzy trading are currently driven by a flow of capital from savings accounts into stocks.

 The current risk is that the speculating could be driven higher to a large degree by active speculation by unsophisticated Chinese investors. China has one of the highest savings rates in the world, so there is ample capital on the side waiting to be funneled into stocks. In our view, this is a real concern, as a run to the exits from the masses could result in a major correction. This would ultimately impact stock markets around the world. Watch this situation.

 In addition, inflation is on the rise in China and this also resulted in interest rates trending higher. According to China’s National Bureau of Statistics, the country’s inflation rate in August reached a 10-year high of 6.5% due largely to a strong 18.2% year-over- year rise in food prices. More amazing is the fact that the cost of meat, eggs and vegetable surged 49.2%, 23.6% and 22.5%, respectively, year-over-year.

 To counter the inflationary pressures, The People’s Bank of China increased the country’s key one-year renminbi lending rate to 7.29% from 7.02%. It was the fifth interest rate hike this year. The central bank also increased the reserve requirement ratio to 13% for commercial banks, representing the eighth increase this year. The increases are all aimed at reducing the availability of money in the system to try to avoid runaway growth, high inflation, and accelerating stock market wealth.

 The bottom line is that higher interest rates do not support a rising stock market unless it is driven primarily by runaway speculation and we know that cannot last.