Broker Check

Stock Volatility and the Situation in China

| August 28, 2023

PROGRAMMING NOTE: We will be taking next week off for Labor Day, returning the following week. Enjoy the rest of the summer with family and friends!

August has expectedly led to stocks feeling pressure globally, with many sinking to two-month lows. A recent reason for some of the downward momentum is bond investors selling U.S. government bonds and pushing yields up to 4.23% as of this writing, which is close to the highest level since 2007.

Bond investors must think interest rates will stay “higher for longer” (although our readers know we aren’t convinced of this narrative yet). When current rates pay less than what investors think will be paid in the future, current bonds are worth less. Thus, they’re sold, driving yields higher.

Even as U.S. economic data continues to beat expectations, stocks have been paying the price for those higher bond yields. But bond investors have done this before. Those past instances gave a great excuse to beat down stocks only to buy them back lower when there's a reversal in yield trends:

Fueling this interest rate story was the most recent Federal Reserve minutes, which showed persistent inflation worry. But inflation has gone from 9.2% to 3.2%. In our humble opinion, this is merely a convenient excuse for seasonal August volatility during a time period with minimal liquidity.

Of course, the media hasn’t helped. It’s driving stock volatility too via all the China liquidity fears being stoked (more on that later). Frankly, it’s gas on a burning fire at this point.

Remember, when liquidity thins, it’s a precursor for increased volatility. Add in some scary headlines and it can scare the pants off investors. Nothing would make algorithmic traders happier than to force capitulation days while scared investors exit.

It must be said that this is normal, though. We’ve shown the below illustration before because it holds true. There is a distinct cycle to “big money” investing (right now, we're in the middle of transitioning from phase three to four):

Throughout August we have eyed the Fed’s annual conference in Jackson Hole, Wyoming, where Fed Chair Jerome Powell will speak. These annual speeches can be market catalysts. We’ve long viewed it as an important day for markets and this year is no different.

So, we’ll use Jackson Hole as a “kick off” of sorts to show how, despite the recent rise in rates, we believe there are four fundamental and tactical reasons that market probabilities will begin to favor equities in the short term. They include:

  1. Jackson Hole bump

Since 2003, data shows an 80% probability that markets will rally after the Fed’s Jackson Hole conference. In that span, the S&P 500* has been down entering the conference seven times. In six of those instances, equities rose the following week with a range of gains from 0.5% to more than 5%:

There's a high probability that the recent surge in the 10-year Treasury yields further threatens future economic tightening. If so, that would lead to more dovish language from the Fed.

  1. Softer inflation

Many analysts support the view that forward inflation pressures are decreasing faster than expected. For example, you can see in this Wall Street Journal article how new hire pay is now declining versus a year ago:

That’s something the Fed wants to see. This data flies in the face of those arguing that that higher pay is “sticky.”

Another recent Journal story highlighted the surge in auto loan delinquencies:

Should these poor market dynamics continue, it would support auto prices falling faster than originally projected:

These new data points support the argument that future inflation will be softer. And if that’s true, it will allow the Fed’s path to turn dovish sooner.

  1. Rate rollover

From a technical perspective, while rates have been pushing higher, equities have been showing early signs of divergence. This would be an important development indicating that stocks think interest rates will begin to roll over soon:

  1. Potentially supportive data haul

This week there’s a huge slate of macro-level data set to be released, including:

  • S&P/Case-Shiller U.S. National Home Price Index
  • Job Openings and Labor Turnover Survey (JOLTS)
  • Second quarter gross domestic product (GDP)
  • July personal consumption expenditures
  • August employment
  • August manufacturing

And that’s just a few items. Our expectation is that all this macro data will provide additional support for a flight path to lower inflation and a softening labor market. Again, these are things the Fed wants.

In summary, the fact that equities are currently oversold along with all the short-term data explained above provides a glimpse into how stocks are in (or about to be in) the bottoming range. From there, they could rise on the strength of economic resilience and expected strong corporate performance, especially heading into Q4.


With all that’s being said about China lately, we’d be remiss not to provide some analysis of our own. We have been bearish on China (and emerging markets in general) for years. We’ve long believed the risk/reward analysis for these investments pointed to unfavorable outcomes.

Recent data validated this decision. The past has revealed Chinese real estate and wealth management issues, though they avoided a “hard landing.” However, the fact that it didn’t happen yet doesn’t mean it won’t ultimately happen. Failings of real estate developers and issuers of wealth management products are sounding alarms amongst investors.

Furthermore, China has once again slipped into deflation. The latest year-over-year inflation rate is now -0.3%:

Past deflationary periods were because of issues plaguing the global economy. This time around, it’s localized. Economies around the world are currently holding up despite China’s issues.

This may be a sign of much bigger domestic problems than the nation will ever admit to – remember, the Chinese government isn’t too transparent. In 1993, China had a nasty recession that was never officially acknowledged by Chinese authorities. But it showed up in bank loss provisions they forgot to doctor.

In that case, there was “officially no recession.” Yet the significant devaluation of the Yuan ultimately was a contributing factor to the onset of the Asian financial crisis in 1997. Thus, the biggest risk posed by the current economic problems in China is if it reverts to using currency as a weapon again because it feels there’s no alternative:

What could lead to such a position? Well, a teetering Chinese real estate market is especially bad for domestic demand as many Chinese residents effectively use a reported 60 million empty apartments as their savings accounts.

What is the risk for investors?

Using history as a guide, we looked back to Japan beginning in 1989. Around then, Japanese investment pools, corporations, and individuals were buying up trophy properties everywhere.

An example is when the Mitsubishi Estate Company bought an 80% stake in Manhattan’s Rockefeller Center for $1.4 billion in 1990, envisioning $100-per-square-foot rents (they were about $33-per-square-foot at the time). By early 1995, investors lost more than $600 million and put the property into bankruptcy protection. Investors also overpaid for Van Gogh paintings, Hawaiian hotels, Pebble Beach Golf Links, and more.

During this time, the Japanese Yen greatly appreciated against the U.S. dollar and the Nikkei 225 stock index was at an all-time high on the last day of December 1989. But that bubble burst in 1990 as the Nikkei 225 retreated 50%. As of last Friday, the index was still 20% off its peak from 33 years ago.

Interest rates in Japan at this time hovered around 2.5%, creating easy access to credit. There was also low unemployment and accelerating economic growth. That all stoked the 1980 Japanese stock market rally. Today, Japan's national debt is now pushing 280% of GDP due to an aging population that is putting a growing strain on public finances.

Does this seem like what’s beginning to happen in China? In the first quarter of 2023, debt as a percentage of GDP in China soared to 279.7%, an increase of 7.7% from the previous quarter:

China faces other Japan-like challenges too.

For one, the nation has a big problem with its increasingly aging population. The decades-long policy of forcing just one child per family has created a scarcity of workers.

Additionally, China’s population has already begun to decline to the point that the economy will have just three people of working age supporting all the pensions of each retiree. Simply put, three workers cannot produce the tax income to support those liabilities:

A third similarity to Japan is that Chinese companies have taken a more cautious approach to hiring new employees. As a result, China's youth unemployment rate has doubled in the past four years. The unemployment rate for young people aged 16-24 has soared to record highs of more than 20% as of May. The situation is so bad that China's National Bureau of Statistics said there will be no future reporting on youth unemployment:

Finally, and perhaps most significantly, China is now running into significant diminishing returns in building “stuff.” Building their own infrastructure and world’s “stuff” has long been China’s economic growth strategy. But there are limits on how far that strategy can go. With so many needs already met today, economists estimate that China has to invest about $9 to produce each $1 of GDP growth. That's up from less than $5 a decade ago, and a little more than $3 in the 1990s.

How China’s leaders handle these issues will provide a better tell as to whether there’s any risk of contagion to global markets. Regardless, it is continued support in our eyes that the risk/reward investment thesis for China doesn’t make a lot of sense.

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* The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market.

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