As the bull market in its eighth year churns on, investor concerns have generally focused on relatively high market valuations and four consecutive quarters of declining earnings for the Standard and Poor's (S&P) 500 Index, as of the first quarter of 2016. Relative to the two previous bear markets, the most recent price-to-earnings (P/E) ratio of 23.59, as of June 23, 2016, was lower than it was in the months preceding the bear market in 2000 and higher than the market valuation in 2007. The earnings recessions that preceded these bear markets were also occurring as bubbles in technology and housing deflated. Considering these metrics, the evidence for a pending bear market is inconclusive.
There are, however, red flags coming out of China that present risks with the potential to dwarf the domestic concerns regarding organic growth and valuations. These red flags are directly related to the country’s soaring level of debt, problem loans and the fragility of the Chinese yuan.
China's Debt
While central banks around the world eased credit policies and increased debt in the years immediately following the financial crisis in 2008, most of them tapered off as their economies gained traction. China, on the other hand, continued to create as much debt in 2014 and 2015 as it did in 2009 and 2010. As a result, by the end of 2015, the country's ratio of debt to its gross domestic product (GDP) increased from 150 to 260%.
The increase in debt is due in large part to the diminishing returns of borrowing to maintain economic growth. In the years preceding the 2008 economic crisis, there was a one-to-one correlation between new debt and economic growth, where a 1% uptick in borrowing resulted in 1% of additional growth in the country's GDP. By 2015, growing the economy by 1% required a 4% uptick in debt.
Non-performing Loans
According to China's official statistics, which includes a category referred to as Special Mention Loans, nonperforming loans have increased by 100% since 2013 and represented 5.5% of total debt at the close of 2015. Estimates outside of China are generally well above the official statistics. One of the highest estimates comes from Société Générale Group (OTC: SCGLY), stating that nonperforming loans will cost banks the equivalent of 12% of the country’s GDP, which translates to $1.2 trillion. The problem of nonperforming loans is further magnified because the financial sector is China's largest, representing 40% of the country's GDP.
The Softening Yuan
After the yuan lost 2% versus the dollar over five trading days in August 2015, the Chinese government responded by selling foreign reserves at a rate of approximately $100 billion per month to defend the yuan and maintain its currency peg to the U.S. dollar. As of April 2016, the defensive strategy had depleted the country’s foreign reserves to three-year lows.
Despite its defense of the currency, a methodical devaluation of the yuan delivers a variety of trade benefits for China, including exports, offshore manufacturing and dollar-denominated earnings, but the country's fragile debt situation may preclude a controlled retreat. To magnify this risk, the inability of the Chinese government to get ahead of unfolding events has left it in a situation of buying time with continued debt issuance. Under these circumstances, the ramifications for China and global economies are likely to increase in scale until an ultimate day of reckoning.
The Impact on U.S. Markets
One potential outcome prior to the bursting the debt bubble is the sale of offshore assets as liquidity tightens in China. Due in large part to the country's slow rate of growth, Chinese investments in the United States set a record in 2015 at $15.7 billion. This trend could be reversed if a falling yuan necessitates the repatriation of dollar-denominated investments.
For U.S. markets, the impact of a deflationary collapse of China's mountain of debt will likely be severe. Considering the market's response in August 2015 when the yuan was devalued by 2%, the reverberations of a downward-spiraling Chinese economy and currency have the potential to vaporize significant market value over a short time frame, and a rock-hard landing is almost a certainty.
