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How China's Stock Market Crash Could Affect Your Portfolio

August 3rd, 2015

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This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.

At the beginning of every month, I brief members on how MoneyGeek's regular portfolios have performed and comment on the state of the financial markets. In this update, Ill explain what the Chinese stock market crash means for the global economy, and what effect it could have on the value of your portfolio.

Performance of Regular Portfolios

The performance of MoneyGeek's regular portfolios for the month of July 2015 were as below:

July 2015Last 12 MonthsSince Apr 2013
Slightly Aggressive +4.1% +21.2% +51.2%
Balanced +3.3% +17.9% +42.1%
Slightly Conservative +2.8% +14.8 % +33.4%
Moderately Conservative +2.4% +11.7% +25.3%
Very Conservative +1.8% +8.6% +17.4%

I've chosen to list below the performance of some of our competitors. For the sake of brevity, I've decided to show only those portfolios that have a similar risk profile to MoneyGeek's Slightly Aggressive portfolio.

July 2015Last 12 MonthsSince Apr 2013
RBC Select Aggressive Growth +3.3% +3.6% +28.5%
TD Comfort Aggressive Growth* +2.1% +7.4% +29.6%
CIBC Managed Aggressive Growth* +3.0% +5.9% +27.7%
Canadian Couch Potato Aggressive +1.4% N/A N/A

*Partial performance until July 30th. July 31st data not available yet.

MoneyGeek's regular portfolios outperformed its competitors in July. In comparison to our competitors, our regular portfolios allocate a higher proportion towards U.S. stocks as well as towards Canadian oil and gas stocks (i.e. XEG). U.S. investments got another lift thanks to the ever stronger U.S. dollar, and it also helped that BRK-B outperformed the rest of the U.S. stock market. However, those positives were partially offset by XEG, which continued to underperform in July. In fact, I would say that theres a full blown panic regarding oil and gas companies right now.

In my free book, I wrote that there will come a time when stocks crash because everyone feels afraid. I wrote that in such times, its important to ignore the negative headlines and stay the course with our investments. I believe that now is such a time, specifically with regards to resource (i.e. oil & gas and mining) sectors.

One of the reasons resource stocks did so poorly last month was because of the Chinese stock market. Between the summer of 2014 and June of this year, the average Chinese stock more than doubled its price. But prices have crashed since then, falling roughly 30% from June until now.

In the rest of this article, Ill explain why investors are spooked by the crash in Chinese stocks, and Ill offer my opinion on what is likely to happen next.

How Stock Prices Affect The Economy

In order to understand the significance of the crash, we need to understand why Chinese stocks rose so dramatically in the first place.

For years leading up to 2015, the Chinese stock market was not an exciting place to invest. From the beginning of 2010 to the middle of 2014, the average Chinese stock actually went down by roughly 30%. All that changed in late 2014, however, as the Chinese government started to encourage its citizens to invest in stocks. Let me explain why the government did that.

The Chinese economic miracle of the last few decades largely depended on building stuff. The government initiated large projects to build airports, roads, dams and other structures. In the meantime, it also encouraged private companies to build apartments, factories, and so on. However, a country can only build enough airports and factories before they run out of uses for new ones. This became more and more evident in recent years, as factories lay idle and apartments sat empty.

Recognizing this, Chinese leaders began to devise ways to transition their economy from building stuff, to having their citizens consume stuff. In other words, the government wanted their citizens to buy more clothes, cars, etc. Unfortunately, such a transition normally takes many years, and in the meantime, because of less building activity, the Chinese economy was slowing down faster than the government was comfortable with. In order to hasten the transition from a "building" economy to a consumer economy, the Chinese government urged its citizens to invest in stocks.

Higher stock prices can theoretically provide a stimulus to the economy because those who own valuable stocks feel wealthier. Alan Greenspan, former chairman of the Federal Reserve, once noted that people dont distinguish between the size of their savings account and the size of their investments. Therefore, someone with $200,000 worth of stocks and no savings is more likely to buy a house, for example, than someone with just $20,000 worth of stocks and $30,000 in savings. By having its citizens invest in stocks and inflating the stock prices, the Chinese government hoped that its citizens would start to spend more.

In the early months of this year, all seemed to be going to plan. Stock prices steadily marched higher through the spring, and more and more of its citizens started to invest in stocks for the first time. However, as the stock market shot ever higher, it became apparent that the scheme worked too well. By June, the government became worried that they had created a stock market bubble, and so they started to make it harder for people to borrow money to invest in stocks.

The new measures were successful and stocks started to fall. But again, it became apparent that the measures worked too well. Instead of falling by a manageable amount temporarily, stocks completely fell out of bed and started crashing, seemingly every day. Fearing that this would bankrupt many of the ordinary citizens who had started speculating in the stock market, the government once again intervened. As of the time of this writing, the Chinese government is still coming out with new measures to support the stock market.

Potential Consequences of a Prolonged Crash

If the Chinese stock market continues to crash, we will see the opposite effect to the one brought on by higher stock prices. In a crash, those who invested their savings into stocks will feel poorer, and this will therefore discourage them from spending.

Lower spending by Chinese citizens will lead to greater economic difficulties for China, which will have potentially severe consequences for the rest of the world. However, exactly what those consequences are depends on whether or not the Chinese government decides to heavily intervene in its economy.

Lets first consider the case where the government chooses not to intervene. In this case, as the Chinese economy slows, the economies of the rest of the world will also slow. As legendary investor George Soros said, China has been the economic engine of the world since the 2008 financial crisis. Many countries economies today depend on supplying China with goods and services, and those economies will suffer more heavily as China demands less of those goods and services.

This is especially true with regards to those countries that supply commodities to China. Because of Chinas past focus on building structures, China has far and away been the largest consumer of commodities such as copper and iron ore in the world. Countries such as Australia, and indeed Canada, have been suffering due to the lower commodity prices over the past few years as China has slowed down. If the Chinese economy slows down even further because of the stock market crash, commodity dependent economies will feel even more pain.

As the economies of the world slow down, its likely that the stock markets around the world will take a hit. This will be especially true for mining and oil & gas companies, as the fall in commodity prices will have a direct impact on those types of companies. However, the rest of the stock market wont be spared either, as many large companies do business in China. A Chinese slowdown will have a direct impact on their bottom lines, but it will also affect them indirectly through a weaker global economy.

The above scenario will only play out if the Chinese government chooses to remain on the sidelines, which is something theyve rarely done in the past. If the government does intervene, it will likely do so in one of two ways.

One way the Chinese government could intervene is by embarking on yet another large-scale building spree. In this scenario, the world economy will revive again for a time, which could lift stocks. Commodity prices will jump as well, because China will once again need to consume large quantities of them. Unfortunately, the problem with this approach is that its unsustainable. China will still need to figure out a way to transition their economy to a consumption based one, and choosing this path will have them merely kicking the can down the road.

According to George Soros, another way that the Chinese government could intervene is by starting a war. I know this may sound far fetched at first, but we should remember that people thought World War I could never happen until it did. Im not saying this scenario is likely, but I believe its possible.

War can be an effective way to pull an economy out of a recession. Many economists credit World War II with helping the world pull out of the Great Depression. Wars eliminate much of the unemployment by mobilizing a great number of people. Wars also generate the need to build structures and also to manufacture large quantities of armaments.

In the case of a war, I would expect stocks around the world to fall because of business disruptions. However, I believe that commodities and commodity related stocks would rise because (A) war requires large quantities of stuff and (B) because of likely supply disruptions. Hopefully, we wont see a war, but I believe those will be the financial consequences if China does wage war.

The Likelihood of Things Getting Worse

You will have noticed that none of the consequences I mentioned above are particularly appealing. I believe that the Chinese government knows this too, which is why I personally believe they will do everything in their power to stop their stock market from crashing too heavily. I believe they will be successful at it, since they have the means.

Many pundits question the ability of the Chinese government to prevent a stock market crash, but I have yet to hear a single good argument as to why. I think many people make the mistake of adopting a Western mindset when they look at the Chinese government. In Western countries, the government often prevents itself from intervening in the stock market too heavily, preferring to let the markets take their course. However, I dont think that describes how Asian countries think.

Take Japan, for example. In order to stimulate the economy, the central bank of Japan effectively printed money to buy a great number of Japanese stocks as recently as this year. Since central banks can print an unlimited amount of money, the bank can theoretically buy an unlimited number of Japanese stocks to support the market. There is nothing at all to prevent China from doing the same, though it will likely try other more subtle approaches first.

In conclusion, a Chinese stock market crash, if allowed to continue, has the potential to slow the global economy or worse. However, I personally dont think this will happen, as the Chinese government has both the will and the means to stop the crash from getting out of hand.

This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.