US equity prices grind higher while Chinese equity markets languish in bear territory

We head into our Labor Day-shortened trading week with constructive economic tailwinds at our backs and a busy Washington D.C.-centric political calendar ahead of us. Among the economic data releases last week that fall into the category of “tailwinds” was the revised Q2 GDP reading of 4.2%. The initial reading was a stronger-than-expected 4.1%. Econoday consensus expected the second Q2 reading to reflect a degree of weakness; the opposite was the case. Weekly Jobless Claims remained low at 213K with the four-week moving average dropping to the lowest point since 1969. Consumer Confidence for August, as measured by the Conference Board, came in at 133.4 – well above July’s 127.4 and consensus that was calling for 127.9. Consumer Sentiment for August (f), released Friday, also came in stronger-than-expected at 96.2.

The highlight of this week’s economic calendar comes on Friday with the release of August’s Employment report. A hallmark of the strength of this resurgent US economy— employment—measured both concerning Weekly Jobless Claims, but also, and very importantly, concerning monthly employment reports, continues to drive confidence and sentiment. August’s Employment report is expected to reflect a healthy gain in non-farm payrolls (198k), a drop in the official unemployment rate to 3.8%, continued strength in manufacturing, and an inch up in hourly earnings on a year-over-year basis. Other releases this week that have the potential of moving the market include the ISM Mfg. Index today, International Trade figures on Wednesday, and the EIA Petroleum Status Report on Thursday.

As if all that economic data set for release this week was not enough to keep traders busy, there are nine talks by Federal Reserve officials scheduled for this week—a full one-third of them to be given by John Williams.

US equity markets remain on track to post additional gains as we look to close out Q3 at the end of this month. As we have discussed in recent notes, despite a flat performance in the first half in 2018, US equity markets have regained momentum due, in large part, to better-than-expected Q2 corporate results and a surging economy. Tax reform, consumer confidence, consumer sentiment, healthy levels of inflation, and expectations for more of the same in coming months all continue to contribute to the narrative.

While US equities continue their historic bull run, Chinese equities languish

The encouraging outlook I have been outlining for the US economy and equity markets for the past seven quarters is not one that is shared by all economies around the globe. The Chinese economy and equity markets speak to an entirely different reality. As the Shanghai Composite Index below illustrates, investors in Chinese equities have been suffering under significant valuation compression over the past two-plus years. It has led to a classic bear market.

The fact of the matter is that this compression in the Shanghai Composite, and subsequent bear market, is more significant than merely a question of underperforming other markets around the globe over the same period. Perversely, it almost appears as though the better US equity markets perform, the worse Chinese equity markets do. That inverse relationship is not missed by President Trump or his trade/economic advisors as the administration moves deeper into the imposition of trade tariffs.

On Friday the Shanghai Composite closed at 2,704.18. On a year-to-date basis, the index has lost 17.73%. Over the past 52-weeks, it has lost 19.48%, according to MarketWatch. For some perspective, it is worth considering some longer-term measures of performance as well. The record closing high was established on 5772.19 on October 1, 2007. The post-financial crisis high registered by the Shanghai Composite was on May 1, 2015, 4561.41. Given Friday’s close, the index has lost over 50% of its pre-financial crisis record high valuation.
Valuations are a theme that has been driving investor concerns. Valuations are often thought of in terms of P/E ratios. Currently, the P/E of the Shanghai Composite is just over 10. As with most other emerging markets around the globe, Chinese equity valuations are also thought of in terms of forward-looking guidance and expectations. Given that, despite best efforts by Chinese officials, the Chinese economy remains trade dependent and export based.

Without question investor caution concerning Chinese investment is being driven by the unknown. What will the implications be for the Chinese economy, and by proxy Chinese equity valuations as a result of the trade war that is gaining momentum between China and the United States? If equity prices are a proxy for what investors are expecting in the future, it is clear that investors expect China to come out of these trade wars on the losing end.

Additional concerns have clouded the outlook for Chinese equities as well. Burdensome government regulation, stubbornly elevated levels of corporate leverage, and resulting balance sheet concerns all contribute to investor caution.

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