The China panic

When we look at the crisis in China, we should understand that even though China is a huge manufacturing economy, it is tiny as far as world financial markets are concerned. It doesn't have a fully tradeable currency in the same way the Australian dollar has. I pointed out last year that China's participation in the global capital markets is only slightly larger than Australia (see footnote), so it's tiny. If you compare the size of the US capital market and the international capital market, the US capital market is around 30 times as large in terms of its international effect as the Chinese capital market. So, while major things can happen in the Chinese economy, they don't have the same effect on financial markets as if the same things happened in the US economy.

We are in a situation where the data in China is really very bad, but by the same token the data for the US is really very good, so in the medium term at least we're going to be saved by the fact that the US data is good even though China is looking pretty weak.

The Chinese Economy

The outlook for the Chinese economy this year if this hadn't happened can be gauged by looking at the International Monetary Fund forecast that was issued in the middle of January. Then growth was expected to be 6%. That was before the impact of the coronavirus. Last week, the OECD put out a forecast of 4.9% growth for the full year, and in my quarterly I'm even more pessimistic. I think the growth rate will be 4.2% this year, rising to 5.7% next year. The reason I'm so pessimistic is that the numbers for February as reflected in the PMIs (we actually model the PMIs and their effect on the Chinese economy) are truly terrible. It suggests that about 7% of the Chinese economy was shut down for the month of February. If that kind of result continued through the year, you'd have the worst result China has had since the Great Depression of the 1930's.

The scenario that the OECD, the IMF and I now have is that from a very low point at the beginning of the year, it's possible for the Chinese economy to gradually recover through the year. This can happen for one of two reasons. Either the virus is finished and dealt with, or they just have to put up with it and get the economy back in shape. Should you leave an economy in this stage of shutdown for an extended period you would have an enormous current account crisis in China. This is something I don't think they can tolerate.

I think what's going to happen through the year is a gradual increase in Chinese output, particularly in large government-owned enterprises such as coal, oil and steel which would recover first. I think that is positive for us but we have to see the data coming through.

The Effect on Financial Markets

I'd like to point out that when the actual industrial data comes out for February it will be a very bad number and I think it will have a further downward effect on markets. However, having given you all the bad news about China, again, when we look at our model of the US economy, what you'll see is our model of US GDP shows it's knocking out solid 2% growth this quarter and solid 2% growth next quarter. And that's really important because the US is far more important for financial markets than China is.

Why did the market fall so fast? Well in Australia it helps that the ASX200 was vastly overvalued to begin with. Not over valued enough to generate an end of cycle bear market but enough to generate a solid correction. Our current fair value for the ASX200 is 6548. That's probably about 50 points lower than when I last talked about this in January. That means that the market peaked at about 650 points too high. Yesterday trading at 6435, it is 113 points too cheap, but you'd expect it to go another couple of hundred points below that. The real problem is in the US market where it also went 550 points too high, getting up to 3393. Our fair value for the S&P500 is 2846. Yesterday at 3000 points it was still 150 points overvalued. We have to go downwards a bit more but the US has a significant correction to reach fair value.

The Fed is doing as I expected in supporting financial markets by cutting the Fed funds rate. The RBA has started that process, which will support our financial market. But we've still got a bit more of this shock to take in terms of downward correction before I can give you extremely positive news, hopefully in a few weeks' time.