It is no secret that China has become the marginal player in the past decade in terms of global economic growth and commodity consumption. No longer is it that when the U.S. catches a cold the world sneezes, as it is now China that drives world markets. It would then make sense to spend a considerable amount of time watching the Chinese stock market. The stock market leads economic developments and China’s stock market leads world stock markets, so tracking the Shanghai can provide considerable warning for investors. The message from Shanghai stock index is definitively bearish as the index has already entered bear market territory, and it appears that commodities are catching up to the prior weakness in the Shanghai, which has yet to find a bottom.
Shanghai & Commodities Breaking Down
The Shanghai Stock Exchange Index has been a great leading indicator to the U.S. stock market and commodities since 2007, both peaking and bottoming typically months in advance. The Shanghai peaked in the summer of last year and then traded sideways into 2010 until breaking down recently. The index broke a rising trend line that went back to the 2008 bottom and it appears commodities are beginning to be dragged down as well as the Baltic Dry Index also recently broke a rising trend line that had been in place since its 2008 lows.
Source: StockCharts.com
While government statistics coming from China are released with a lag, there is a clear declining trend in financial and economic indicators that correlate with the weakness seen in the Shanghai which show no signs of a turnaround. This has negative implications for commodities that are also in a topping process. The Chinese M2 money supply growth rate is falling as is the leading economic index (LEI) for China which lead general trends in commodities such as copper, oil and the Baltic Dry Index. Another indicator that typically leads commodity trends is the Chinese PMI New Orders Index which peaked several months prior to the CRB Commodities Index peak in 2008 and bottomed several months before the CRB bottomed as well. The PMI New Orders Index remains in a declining trend with commodities likely to remain under pressure until a bottom forms.
Data Source: Bloomberg
Data Source: Bloomberg
It is unlikely that the Chinese LEI is going to improve any time soon as the performance relationship between Chinese cyclical stocks versus non-cyclical stocks continues to worsen. The relative performance between the cyclical and defensive sectors leads the Chinese LEI by several months and the relative performance between the two made a new low which implies the Chinese LEI will continue to weaken throughout the summer.
Data Source: Bloomberg
One Saving Grace?
While Chinese monetary and economic indicators and sector relationships suggests the Shanghai Index will remain weak for months to come, one caveat is that the USD Index is on the verge of breaking its rising trend that has been in place since December of 2009. A breakdown in the USD Index would likely be a tailwind to emerging market equity relative performance which in turn has a strong correlation to commodity prices. A bottom in the Shanghai Index may be from market participants who believe Chinese officials will see a slowdown in economic growth and ease up on their recent tightening policies. That coupled with a slight revaluation of the Chinese Yuan may put in a bottom in the Chinese growth deceleration and in the decline in commodity prices.
As shown below, the USD Index is at a key technical point (shown inverted below in the top panel) as it is testing its trend line as is the relationship of emerging market stocks (EEM) to the S&P 500 (blue line, middle panel) and the Shanghai’s relationship to the S&P 500 (red bottom panel). A breakout in the relative performance of China and emerging market equities coupled with a breakdown in the USD Index would tend to suggest the recent market route may be over for now. If clear breakouts in emerging market relative performance and breakdown in the USD Index do not materialize, then the recent strength in emerging markets and weakness in the USD are likely a pause as markets do not move in a linear fashion indefinitely.
Source: StockCharts.com
As the relative trend in the Shanghai has important implications for global economic growth and commodity price trends, I’d keep an eye on the Shanghai as a useful barometer of where financial and economic winds are to blow next.
