Wall Street Is Worried About China, But You May Not Need To Be

The U.S. economy should stay in pretty good shape, as long as people don't overreact.

Financial markets have been signaling that investors are increasingly worried about how China’s slowdown will hurt the U.S. economy.

If you rely on your stock holdings to fund your lifestyle -- whether as a hedge fund titan or as a retiree -- you're probably justified to worry about the market.

But as a typical American who wants steady economic growth and all the advantages that come with it -- rising wages, improving home values, little fear of joblessness -- there’s probably not much reason to worry, experts say.

The key concern for investors is that China’s economy isn’t growing as fast as it used to and its factories won't demand as many commodities, such as oil and metals. That fear has helped drive down the price of oil and the benchmark stock exchange in China by nearly half since June, which is at least partly responsible for spooking U.S. markets.

But it's not as foreboding as you might fear. Here's why: 

The stock market is not the economy 

The Dow Jones Industrial Average is down about 6 percent this year and the S&P 500 has fallen to mid-2014 levels. That’s stoking fears that traders are sending a message that the U.S. economy is in trouble. 

Robert Kahn, a senior fellow at the Council on Foreign Relations and a former U.S. government official and hedge fund strategist, described it as a “China contagion story”: Concerns about China and other emerging markets are causing investors globally to dump risky assets, such as junk bonds and stocks. “It’s all about confidence,” Kahn said.

The U.S. economy is still estimated to have grown by 2.4 percent last year -- the same level as in 2014 -- and forecasters reckon it’ll expand by more than 2 percent this year and the next. Wages and home prices are forecast to go up, the unemployment rate is at 5 percent, and household debts are near a 35-year low. 

As Brian Jacobsen, chief portfolio strategist at Wells Fargo Funds Management said, "These are not the makings of a recession." 

U.S. firms export few of their products to China when measured against U.S. economic activity, said Charles Collyns, chief economist at the Institute of International Finance and formerly a top official at the U.S. Treasury Department.

U.S. companies and households buy from China -- they don’t sell much to China -- so a China that isn’t growing as fast shouldn’t by itself damage the U.S. economy.

For example, China accounts for about 1 percent of the combined profits of companies that make up the S&P 500, according to Howard Marks, co-chairman of Oaktree Capital Management, the $100 billion asset manager.

Economists at Goldman Sachs this month forecast that even if China’s economy worsened, it would subtract at most around 0.3 percent from U.S. economic growth.

Moreover, there are four reasons why problems in U.S. stock markets may overstate broader economic weakness, Goldman Sachs economists said last week:

  1. Energy companies constitute a much larger part of benchmark stock indices than they do overall U.S. economic activity. Energy stocks have plummeted over the past year, dragging down the S&P 500.

  2. When publicly traded companies report sales and earnings, those figures include the effect of inflation. With Wall Street expecting reduced inflation, that could lead investors to expect lower quarterly earnings. Less profit typically leads to lower dividend payments to shareholders, driving down stock prices.

  3. Corporate profit margins are falling. In recent years they had reached new records, thanks to relatively high unemployment and workers’ inability to command higher wages. Today’s stronger labor market is leading to higher wages, eating into companies’ profitability and stock valuations.

  4. Publicly traded companies are typically much larger than privately held firms. Bigger companies tend to sell more of their goods overseas. For example, 33 percent of revenues of the typical S&P 500 company comes from abroad, but total exports account for less than 13 percent of U.S. economic activity. A stronger U.S. dollar -- it's up about 20 percent since July against a basket of currencies tracked by the Federal Reserve -- has a bigger negative impact on the S&P 500 than it does on the overall U.S. economy.

A weaker China doesn't mean a weaker U.S.  

Chinese authorities reported last week that the world’s second largest economy grew at an inflation-adjusted 6.9 percent clip last year, the slowest pace since 1990. Even though the rate of growth was in line with the government’s target of about 7 percent, the figure spooked markets.

That’s because China’s economy, which in recent years has been a big driver of global growth, may be slowing down faster than experts expected. The Institute of International Finance predicts that China’s economy will expand by about 6.4 percent this year, an estimate that assumes Chinese authorities will continue their extraordinary support of the economy.

Chinese authorities recognize that the nation’s economy no longer can be primarily led by industrial activity, so over the past several years they have been trying to steer it into a services- and consumer-led economy.

But many investors doubt China’s ability to accomplish its goal. Corporate debt in China has skyrocketed in recent years, and many experts fear that Chinese companies will have difficulty making good on their obligations. They also worry that China’s industrial sector is in worse shape than official government figures indicate.

The Shanghai Composite Index is down nearly 23 percent this year but about 47 percent since June, potentially reflecting a burst bubble.

Federal Reserve policymakers worry that China “could find it difficult to navigate the cyclical and structural changes under way in its economy.”

Meanwhile, the yuan is back to 2011 lows against the dollar. A cheaper yuan helps Chinese exporters, since it makes their products less expensive. But recent abrupt moves in the value of the yuan, and the concerns over the financial health of Chinese exporters, has led many experts to think that Chinese authorities may allow the yuan to fall in value in order to help the country’s ailing manufacturing sector.

If Chinese officials ultimately decide to let the currency fall, many would interpret the move as evidence that China’s economy is worse than official figures indicate. Officials there also employed a series of actions designed to prop up the economy and the nation’s financial markets, but some think the moves may have backfired. 

For example, Chinese authorities have tried to halt falling stock prices, to no avail. One measure that sought to curb panicked stock sales instead “may actually be pushing investors to rush to sell quickly,” Institute of International Finance analysts said. “The authorities’ responses look not only heavyhanded but poorly designed,” the analysts noted in a recent report.

China’s Vice President Li Yuanchao last week sought to reassure jittery investors by stating that authorities will propose new policies he said will boost economic growth. Investors have since reacted by sending Chinese stocks lower.

Finance experts say China has mismanaged its handling of internal financial markets and they doubt Chinese leaders’ ability to successfully guide the economy’s transition from one powered by industrial production and exports to one led by the service sector and household consumption.

“Chinese authorities are not particularly experienced or adept at managing market forces,” said Collyns.

But the panic about China’s potential impact on the U.S. economy is “overdone,” he added. 

Wall Street may be making things seem worse than they are 

Even if the U.S. economy is fine, lower stock prices by themselves could hurt growth if households feel less wealthy or if daily headlines about troubles on Wall Street erode confidence to the point that consumers cut back on spending, said David Dollar, a senior fellow at the Brookings Institution and a former Treasury Department official tasked with monitoring China.

Households could reduce consumption by up to 0.4 percent this year, shaving about 0.25 percent from overall U.S. economic growth, according to estimates by Goldman economists.

Emotions that drive households to spend less when they see their retirement accounts losing value affects traders, too.

The International Monetary Fund last week described it as a “sudden rise in global risk aversion.” In this telling, risk-averse investors may be overreacting to fears about Chinese growth and the implication of lower oil prices.

Olivier Blanchard, a former IMF chief economist, said he suspects “herding” is largely to blame. 

“If other investors sell, it must be because they know something you do not know. Thus, you should sell, and you do, and so down go stock prices,” Blanchard said last week. “Why now? Perhaps because we have entered a period of higher uncertainty.”

The U.S. economy is still forecast to grow. The Fed said this week that the U.S. labor market seems to have improved over the last month.

It's not all good news for us, though. If stock prices in the U.S. don’t recover, or if they fall even more, that by itself could damage an otherwise healthy U.S. economy.

“It can become self-fulfilling. Low stock prices lasting for long lead to lower consumption, lower demand, and, potentially, to a recession,” Blanchard said.