A country's stock market is often a leading indicator of its economic performance. In China, two dramatic corrections occurred in the middle of 2015 which translated to the weakness that would infect the global economy. From its peak last year, the Shanghai CSO 300 Industrial Index has lost over 50 percent of its value in a downtrend that has depressed sentiment surrounding the industrial and manufacturing sectors in China. The downtrend has softened but continues to devalue large-cap industrial shares approaching values seen in mid-to-late 2014. As far as projections go, the stock market is predicting the slowdown to maintain the bearish pressure on share prices and the contraction in demand. Investors looking to pump capital back into these Chinese firms need to consider the bubble-like symptoms that caused four freefalls in the past year. This weakness may deter wary traders to flock around these stocks in the future.
The China Caixin Manufacturing PMI is one of the most watched industrial economic indicators for domestic and global demand trends. The index tracks the monthly growth of the manufacturing sector, one of the largest components of China's GDP. Readings above 50 translate to expansion while readings below 50 represent contraction. February 2015 was the last month where an expansion was reported before the drop that occurred later in the year. Just after the major correction in August 2015, the September reading was recorded at its lowest point, 47.0. From there, the contractions have been slowly shrinking to just below 50 in March 2016 which read 49.7. The worst of the losses look to be over with a trough most likely formed in late 2015. The next milestone for recovery will be getting the PMI back into positive growth territory. Demand will only fully come back online when the levels of mid-2014 are approached. But, at the very least, investors shouldn't expect to see the worst again as the Chinese corrections have successfully repriced the stock market in relation to the country's manufacturing strength.
When the Chinese manufacturing and industrial sectors are strong, their consumption of raw materials, machinery, and just about anything else is equally as robust. The relatively undiversified economy of China is required to import huge amounts of these products to support the 40 percent of the economy composed of industry according to 2014 numbers. As the slowdown set in, businesses started to import less. In April 2016, Chinese imports dropped by 10.9 percent to $127.2 billion USD. Compare this number to the March 2013 peak of $183.1 billion USD and one will see a 30.6 percent slide in China's demand in foreign markets. That translates to about $56 billion worth of demand or $56 billion of lost foreign revenue. The loss of this capital has resulted in economic weakness infecting China's biggest trade partners which include developed nations like the United States and Germany. To make matters worse, imports may never recover to the level which they were at peak Chinese development. The emergence of the service industry as a major component of the Asian giant's GDP has created a dynamic economy that can rely less on industrial growth. For exporters, the shrinking of the world's largest source of demand could mean bad news.
The now limited Chinese demand is most bearish for the energy sector as crude oil accounts for about 6 percent of total imports, the largest demand for a commodity. Its regional suppliers have recently felt the negative effects of less oil consumption with weak demand weighing on Brent and OPEC basket spot prices. According to EIA data, members of OPEC already account for 58 percent of China's oil supply with its leader, Saudi Arabia, the highest at 16 percent. Revenues coming from contracts in Asia have decreased amidst the drop in prices caused by shale production. As my previous article pointed out, the weight on cash reserves has increased tension on national social programs and the populace's tolerance for a shrinking economy. Now, the surge of the services sector and a global push towards renewable energy sources further threatens the already fragile Chinese oil consumption. Because its government continues to pursue the goal of a stable energy policy with the appropriate diversification, securing a permanent import deal has become more and more difficult. China has already exchanged the volatile supply of Sudan, Iran, and Syria for deals with its neighbor, Russia. More shifts could be due in the near future and here's who may be affected:
- Saudi Arabia, Angola, and Oman are all countries that supply at least 10 percent of China's crude oil. But recently, the Wall Street Journal reports that Russia has overtaken the trio to take the top spot of on the list of crude oil exporters to China. Instability in the Middle East region, the failure to reach a deal in mid-April, and al-Naimi's firing have all contributed to volatility in the geopolitics of the region and the economic viability of the oil cartel. In the first quarter of 2016, Saudi Arabia's exports to China have only increased by 7.3 percent despite low oil prices encouraging larger increases in consumption. Instead of OPEC members securing Chinese contracts, they will soon find themselves fighting each other for market share if Iranian capacity increases rapidly and a cheap energy environment settles in for the long run. The disinterest of the cartel's biggest customer could mean a more competitive market, or worse, the disintegration of OPEC.
- Russia has had the advantage of being in good terms with China while they shift their supply chains to more secure channels. Deals like the $400 billion agreement between the Chinese government and Russia's Gazprom have given their neighbor preferred access to the demand that has the oil markets fighting for contracts. As Saudi exports fell, Russia logged a 42 percent increase in crude oil shipments to China in the same period. Their status as the top producer in the world has seduced their customers with the prospect of cheap oil for longer with deals done out of desperation so that Russia can kickstart their struggling economy. The new partnership has increased tension present in the rivalry between OPEC and non-OPEC members. The shift in Chinese imports might convince Saudi Arabia and its peers to increase production a threat already used by Saudi crown prince bin Salman. But has Russia won this "race" before it began? According to the EIA, Russia and China have signed a deal to send "up to 800,000 b/d of crude oil by 2018." With the country securing more demand for its enormous oil and natural gas stocks, they might be in prime position to benefit from a stabilization, or maybe a recovery, in energy prices.
- The United States is in a unique position in this changing market. With shale production spurring a renaissance in domestic supply operations, the world's second largest oil importer now has options on the supply side. Energy independence (no imports) may never be in the equation, but the U.S. could begin to balance their energy trade deficit with the ban on exports lifted. However, limitations on Chinese demand could pose an interesting dilemma where domestic oil prices fall, but it becomes cheaper to import foreign. Or, demand wastes away the economic viability of petroleum, and the shale revolution withers away with it. Either way, the United States' supply and demand will turn out to be the counterweight when a winner is finally realized in the global fight for energy market share.
The days of global reliance on Chinese demand are soon coming to end as seen by the decline in growth rate, decline in imports, and increase in service sector strength. The implications have already been great as stock markets across the developed world fell into peril when China's GDP growth rate fell below 7 percent. Withdrawal symptoms may last for awhile until a recovery in demand alleviates some pressure. But one thing is certain, the world's markets will have to adjust to a developed China as what is being called the "new normal" sets in. In the oil market, the effects are even more accentuated with its top customer showing signs of flattening demand. As a result, suppliers will fight to justify their stability and efficiency as China chooses from the desperate bunch. Lately, their choice has shifted from OPEC producers to their neighboring giant, Russia. The energy players and other foreign businesses that once relied on China's robust growth will no longer be able to depend on its expanding demand. A new group of emerging economies will have to step in. Who will they be?