If I had to guess earlier this summer, I would not have expected most major U.S. stock indexes to have reached all-time highs before any concrete results in trade negotiations with China were evident.
In fact, there have been records in both the Dow Jones Industrial Average DJIA, +0.11% (the retail investor’s favorite index) and the S&P 500 SPX, +0.04% (fund managers’ favorite index). Small-cap stocks and the Nasdaq Composite Index COMP, +0.02% didn’t make fresh new highs last week, but they were outperforming all year and hitting records into late August, so the advance in the market is much broader than one might have anticipated in a late-stage expansion.
What is driving this push in share prices to all-time highs? Earnings.
At the beginning of the year, analysts expected earnings per share (EPS) to increase in the range of 10% to 12% for 2018, depending on whether analysts used top-down or bottom-up estimates. Right now, after first-quarter and second-quarter EPS growth came in at 20% and 25%, respectively, 2018 EPS growth is estimated to be 20%.
Naturally, if EPS is growing by 20%, share prices should follow suit.
Clearly, quantitative tightening by the Federal Reserve, global trade frictions and a rout that started in emerging markets’ (EM) currencies (soon spilling into local bond markets and later into emerging markets’ stocks) had the potential to create another crisis, but the crisis is contained at the moment. As we witnessed from 1997 through mid-1998, the U.S. stock market could ignore the Asian crisis — until it didn’t. So the current contrast between a strong U.S. stock market and weak Chinese (and other emerging) stock markets can continue for a while, but ultimately either the EM space will rally or the U.S. market will sell off.
While there was a small recovery off of an all-time low in the J.P. Morgan Emerging Markets Currency Index last week, the situation in the emerging markets space is precarious. Both the Turkish lira and Argentine peso have been cut in half in 2018, and we are still very much in the contagion phase of this crisis. Since the J.P. Morgan EM Currency Index is not widely available other than on a Bloomberg terminal or through FactSet, a good rule of thumb is to keep an eye on the Brazilian real, where forex reserves are ample and interest rates are high. The real, or reais as Brazilians call it, made an all-time low two weeks ago (see chart). The rout in weaker EM currencies is spilling over into stronger ones and the real shows that in real time.
China trade talks deteriorate
Because trade talks with the Chinese delegation slated for this week were canceled just as $200 billion in new tariffs were about to go into effect, one could imagine that the U.S. stock market would have a more difficult time, as the war of words escalates and more and more tariffs go into effect.
Since this trade friction with China started, U.S. and Chinese stock markets have performed differently. Even though the Dow Industrials and S&P 500 lagged the small-cap and technology indexes most of the year, they did much better than the mainland Shanghai Composite and CSI 300 index (see chart).
While in the U.S. small-caps have been outperforming large-cap indexes in 2018, the small-cap indexes in China have been massively underperforming the large-cap indexes. The one-year trailing returns as of last week for the large-cap Shanghai Composite SHCOMP, +1.06% and CSI 300 Index 000300, +1.04% were -16.6% and -11.1%, while the one-year trailing returns for the small-cap Shenzhen Composite 399106, +0.83% and ChiNEXT Price Index 399006, +0.78% were -27.3% and -24.4%.
At one point earlier in 2018, the large-cap indexes in China were rising, while the small-cap indexes were going down. I never trust a stock market where small-caps are notably weak. Sure enough, the wheels started to come off the wagon for large-cap Chinese stocks in earnest in March.
The Chinese are in a precarious situation, as the country’s dictatorship has managed to prolong an economic expansion for 25 years through a policy of forced lending quotas. While such policies helped the Chinese economy expand more than 10-fold, total credit aggregates in the economy increased more than 40-fold. We have a credit bubble in China, which will have nasty consequences similar to what happened in Asia 20 years ago, with the caveat that the Chinese economy is several times bigger than all of the countries involved in the Asian crisis at that time.
Loan growth, despite a small uptick of late, and fixed-asset investment growth have both been declining for a while, and it very well may be a real trade war with the U.S. that pushes China over the brink (see chart). China’s government has every incentive to make a trade deal, yet the abrasive approach of the Trump administration that produced results in the case of Mexico and the EU may be counterproductive with China, because it runs counter to the “saving face” modus operandi of Chinese diplomacy.
Ivan Martchev is an investment strategist with institutional money manager Navellier and Associates. The opinions expressed are his own.
Providing critical information for the U.S. trading day. Subscribe to MarketWatch's free Need to Know newsletter. Sign up here.
