Motorists stay safe with help from street signs: Bumpy road ahead! Potholes! Curvy road next 10 miles! If only we had such diligent forewarnings for bull markets—which are often more akin to big-rigs than sports cars zipping along the interstate. Fact is—to get long-term, equity-like returns, the road is never as straight as the crow flies. Buckle up and hold on. This is particularly true during the early stages of bull markets.
China's Shanghai A-Share index recently hit a pothole, relinquishing nearly 20% from its August 4th high and crossing a widely recognized bear market threshold. But investors needn't read too much into this pullback.
The correction hit after Chinese shares nearly doubled off their November 2008 bottom—a huge move, to be sure, but not atypical of emerging market volatility. Admittedly, a 20% drop might seem massive compared to typical developed market bull corrections, but China's not a developed market. Using the same market definition of a bear for an emerging market like China is misleading—the ups and downs are normally bigger. Further, the so-called A-Shares aren't a suitable indicator—capital controls keep non-Chinese from investing in this market and Chinese from investing in anything but. It's convoluted, and that's part of what distorts things.
But what might be causing Chinese stocks' skittishness? One potential contributing factor could be worries China's huge fiscal and monetary stimulus may soon be reined in. A few government actions seem to be signaling as much. In July, the government re-issued one-year central bank notes to sop up excess liquidity—similar to a move in May 2003, just before a two-year period of monetary "tightening" in China. And that's not all. Like in 2003, officials are aiming to "talk down" loose lending.
Like any set of politicians anywhere, look for deeds, not words. Global economic conditions today are weaker than in 2003,[i] and Chinese officials won't likely take significant action until global demand picks back up—staving off any major tightening for now. Chinese monetary supply continues to grow, and even if that torrid pace is staunched a little, the environment is still very accommodative and conducive to growth.
Yet not all hinges on stimulus. Even after stimulus measures dry up (probably a long ways off since much of Chinese stimulus is aimed at building infrastructure), China's long-term economic potential remains. Productivity gains, market liberalization, and increasingly normalized relations with its neighbors all contribute to China's future growth prospects. And a large degree of China's demand is internal—the country's economy isn't as export dependent as widely believed. In fact, in recent years, China has become a net importer of energy, materials, and a variety of capital goods—even food is imported.
Age demographics (mostly young with a smallish percentage of aged folks, relative to developed nations) and migration from rural to urban (farms to factories) further paint a picture of a country with a lot of room to grow. It's also worth noting the recent economic resurgence has been fueled by both efficient stimulus implementation and semi-private investment—indicating real growth behind the government numbers. To be sure, China is still red, but the momentum is toward liberalization and opening borders, not the other way around.
In all, China's recovery could have more staying power. Global investors should fasten their seat belts—there'll be more bumps ahead, but that's just the path of a rising stock market. This is one ride you won't want to miss.
[i] Fisher Investments Research.