The bottom line here, in our view, is that central banks need to adjust the policies that have been in place since 2009, when they switched from inflation targeting to forms of quantitative easing and zero interest rate policy (ZIRP).  In the wake of the financial crisis they were looking for a “wealth effect”, keeping down financing costs, expanding the credit cycle and hopefully boosting lacklustre economic growth.  The problem is that this policy has only resulted in inflating financial asset prices rather than move economies forward.  Excess liquidity and loose monetary policy have led to inflation, not in the real economy, but in financial markets.  But no one calls that inflation; they call it a ‘bull market!’  The sharp pullback in stocks we are seeing is, in our view, a recognition that the gains have not come for the right reasons and that markets have been supported by these ‘ZIRPs’ and not by corporate and economic fundamentals.

Back to the problems in China being the ‘catalytic event’ for the current downturn in financial markets, the biggest indicator of the magnitude of China’s slowdown can be found in the global commodities market.  The Bloomberg Commodities index now at a 13-year low.  Copper is down 18% for the year, tin is down 30%, lumber is off 32% and nickel is down 33%.  These commodity prices began to plunge concurrently with China’s steep drop in officially reported GDP growth, to under 7% today from 12% in 2010.  But the real growth rate in China is probably closer to 4% when measured by private data.  The true message of plunging commodity markets is that the Chinese government overdid the stimulus by using $20 trillion worth of credit on infrastructure spending to mollify the fallout from the Great Recession of 2008, primarily creating a huge fixed-asset bubble with little economic viability.  Then it forced another $1.2 trillion in margin debt to engender a consumption-based economy, primarily by creating a stock-market bubble after the fixed-asset bubble strategy began to fail miserably.  These problems will not be solved by some further interest rate cuts, looser bank lending standards or currency devaluations

August marked another painful month for Chinese stocks, with the country’s Shanghai Composite Index slipping another 12.5%, its worst monthly loss in six years.  Despite renewed state intervention to calm China’s markets, slowing growth has investors projecting an even bigger selloff.  They have thrown in everything but the kitchen sink trying to stop this market from falling.  Amid the selloff, Beijing moved to freeze shares of some companies, put off IPOs, and encouraged state-owned companies to buy more blue chip stocks.  They also prevented major institutions from selling stock positions.  But, in the end, they will find that you just can’t ‘legislate a bull market in stocks.’  Our best advice is to ‘remain on the sidelines’ for most emerging markets.

The Wild Ride in Chinese Stocks

While investors are myopically focused on the U.S. Federal Reserve and whether they ‘will or they won’t’ raise interest rates at their September meeting, we continue to believe that the net impact on economic growth and real business activity of this potential ¼ point move is hugely over-stated.  The Canadian and U.S. economies survived the 1980s with interest rates at ‘double digit’ levels.  Whether short-term interest rates in the U.S, are at 0.25%, 0.50%, 1% or even 3% won’t impact real economic activity to any great degree.  The Fed just needs to ‘rip off the bandage’ and let financial markets find their own, appropriate levels, without the ‘financial heroin.’  Some evidence that economies can actually extract themselves from downturns and even financial crises without the continued help from central banks can be seen in Iceland, of all places, which went through their own financial crisis prior to 2008.  But they are an interesting case study in that they ‘did the opposite’ of everybody else (to coin a Seinfeld phrase).  Before the credit crisis, the country had AAA credit rating but, when the crisis hit, they did not move aggressively to protect lenders, as opposed to everyone else who bailed out creditors and maintained strong credit ratings by effectively printing money.  Today, Iceland’s economy is on track to grow over 4%, (three times the Eurozone growth rate), the country’s unemployment rate is below 3% and it’s on track to achieve a trade surplus equivalent to 6.7% of GDP.  In the end, higher interest rates forced out bad creditors and ultimately lead to higher growth, lower unemployment and a higher trade surplus.  Go figure!

In terms of our investment strategy following the severe downturn over the past month, we are still somewhat cautious.  We are not expecting a full-blown bear market in global stocks (i.e. losses of greater than 20% continuing over a period of over 6 months) since we are also not expecting the global economy to slip into a recession.  However, we have been expecting a stock market correction of at least 10% and have continually said that this could easily turn into a 15-20% downturn as the excesses of the past few years of stock gains were unwound.  But on the positive side, the global economy continues to expand at a slow rate, inflationary pressures are still not visible and interest rates are expected to remain low by historical standards.  While stock valuations cannot be considered low (as shown in the following chart), they are not significantly above the long-term average.

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