With a Greek Deal Nearly Done, Is China the Next Threat?

By FOXBusiness

After a relatively calm start to the summer, U.S. investors were hit with a one-two punch from growing worries over the stability of stock markets and economies half a world away.

A deal struck in the wee hours of Monday morning between Greece and its international creditors on a new bailout deal helped quell growing global anxiety over a so-called “Grexit.” The deal brings a near-certain conclusion to drawn out, tense negotiations between the debt-laden nation and its eurozone counterparts.

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But now, some wonder what the next threat might be, and increasingly, what looks to keep some investors up at night is action in the world’s second largest economy: China. After a sharp run up in China’s equity markets  in the last month China’s Shanghai Composite Index dropped more than 30%, and crashed into bear-market territory in late June. The last two weeks have brought tumultuous trading and extreme up and down days. But for all the attention the recent selloff has garnered, the index is still up about 22% for the year.

While some wonder whether this is the bottom for the Chinese market, Bank of America Merrill Lynch said in a research note Friday the action in that market could be a possible trigger for a broader Chinese financial crisis.

“If the market continues to fall sharply, stock lending related losses could turn into Rmb trillions [ 1 Chinese Yuan equals 16 U.S. cents], of which banks and brokers may have to bear a meaningful share,” the note said. “Even more important, the opaqueness of China’s financial system and the lack of clear definition of risk responsibility mean that contagion risk is high, similar to the subprime crisis.”

In an effort to hold up its financial markets and prevent steeper losses and eventually a crash, China’s government and regulators have enacted several measures. In recent days those entities have disallowed large stakeholders in publicly-traded companies to trade their shares; banned short selling in equities, and suspended trading on more than 1,000 of the market’s securities.

To that point, Allianz chief economic adviser Mohamed El-Erian advised caution to FOX Business’ Maria Bartiromo.

“That is the normal reaction in a place like China, to do administrative measures and try to control the situation. Two things to look at going forward: Can they sustain the rebound in the stock market? And secondly, more importantly, can the market resume normal functioning?” he said. “The market is still not functioning properly. It’s still early days.”

Richer or Poorer

Merrill Lynch noted what happens from this point on is a kind of wealth transfer from the rich to the poor.

“The net result of this volatile market is a transfer of wealth from the people on the street to the wealthy, including many major shareholders who cashed out. We expect this will likely hurt consumption down the road,” the note read.

That’s due to the crash in both China’s A shares, owned primarily by retail investors who in 2011 accounted for 80% of the daily trading volume there, according to Merrill Lynch; and H shares markets, generally owned by large shareholders and corporations.

“The source of the China rout was this bubble created by retail investors, which infected the China H shares market,” Clem Miller, portfolio manager at Wilmington Trust said. “H shares routed too because investors around the world were saying, ‘dump everything China.’”

Miller suspects when the dust settles and the recent regulations governing the equity markets lift, the H shares will rally again because they’re full of ”strong” Chinese companies that are fairly insulated.

“The A shares market is a more complex issue where it’ll take longer to bounce back after this route because so much damage was done to it because of the boom and the mismanaged reaction by Chinese authorities who tried to stop the rout but couldn’t because it was moving too fast,” he said.

To that point, the Merrill Lynch China equity strategy team noted that outflows from the A-shares market have accelerated. In the first five months of this year, the total amount of capital raised in primary and secondary offerings by companies in the A shares reached approximately $85 billion, a 77% year-over-year increase. However, during the same period, major shareholders sold about $57 billion worth of A shares.

“At this pace, these two sources of cash drain alone will amount to some [$338 billion] in 2015,” the team noted. “Based on their relative scales, we believe that the following factors are the most important. 1) Government’s attitude on stock-related lending activities; 2) retail investors’ stock appetite; 3) insurer’s attitude on A-share market outlook; and 4) major fund raising activities.”

Commodities Slump

As debate rages over what influence China’s teetering stock market has on various economies, and the global economy as a whole, many analysts say the commodities market is where China’s effects could really hurt the most.

That’s because China is the world’s biggest commodities consumer. As Albert Ambrose, a 40-year veteran of the commodities industry notes, the downward trend in across-the-board prices could largely be due to China’s slowing demand.

“What I think most people miss about China is it has been a juggernaut for the last 30 years for economic growth, but the majority has been export-driven. The problem with that kind of economy is all the customer bases – Europe, the U.S., Japan – are mired in debt, unemployment issues, and they don’t have consumer purchasing power that they had through the ‘90’s and the first part of the century. The demand structure isn’t what it once was,” Ambrose said.

He added that China can do as much propping up of its equities market as it wants, but what’s happening in the overall Chinese economy right now is something they can’t “manipulate their way out of.”

The Merrill Lynch global commodities team also noted that China and commodities go hand-in-hand, and there is not much appetite by the government there to make worse existing overproduction in various markets like steel.

“China is the world’s largest producer of aluminum as well as the largest consumer, but it is facing the highest production costs in the world, on average. This distortion has not prevented China from exporting its aluminum surplus at a loss in recent quarters. The picture is similar for iron ore, another key commodity for the Chinese economy,” the team noted.

The note went on to say that high production costs and slowing demand in its own economy will likely weigh on commodity prices in the coming months.

Copper is considered a global economic barometer for its wide-ranging uses in technology, manufacturing, home building, etc. Merrill sees copper hitting $5,000 by the end of the year thanks to a slowdown in major copper-consuming sectors including power, transport, electronics and construction.

“I’m beginning to feel like this setback that’s experienced in the developed world is finally taking a toll on China,” Ambrose said. “There’s too much debt, too much overbuilding. The indicators I’ve used over the last few years, other than soybean and protein, are copper, cotton, and crude oil. They have all taken a rather disastrous turn.”

China’s Impact to U.S. Seen as Minimal, but Not Unimportant

As for how China is likely to impact the U.S., many analysts say, it probably won’t hurt that much on the Western side of the world.

“I don’t think it’s a big issue right now for U.S. investors. Not yet,” Joe Quinlan, U.S. Trust chief market strategist said. “I don’t think it’s going to do a lot of damage to the real economy. They’re still exporting, importing, buying goods. It’s not leading to a significant downturn.”

The only concerning part of this whole story is if capital problems begin to pop up in China. He noted it's important for U.S. investors to monitor since China is the United States’ biggest creditor, owning about $1.2 trillion in Treasury bonds.

“We’re a big debtor, they’re one of our biggest creditors. We need them to have their own solid financial footing for all of our own good,” he said.

Quinlan also pointed out despite the considerable drop in the Chinese market, both the stock market and economy are still growing at a significant pace.

“This will be contained. And when it is, they’ll still grow 5% to 6% this year. The growth problem is in Europe, not China. If we see daily instability, then yes, it’s a bigger risk to the U.S. growth and the Fed. But not yet,” he said.

El-Erian added that he doesn’t see China as an investible place at the moment, but in the U.S., the downside risk from China is fairly limited.

“We’re going to deal okay with the headwinds from abroad, but as long as Congress is polarized, and as long as we don’t get some important measure to help this economy, we’re going to continue in third gear when we could be in fifth gear.”

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