The stomach-churning plunge in Chinese stocks is taking a heavy toll on Canadian markets, and Beijing's failure to stanch the bleeding threatens further volatility in the weeks ahead.
China's Shanghai composite tumbled 8.5 per cent Monday – that's the equivalent of a 1,200-point drop in Toronto – as government support of equity markets could not stop the majority of stocks from falling by the maximum 10 per cent limit.
The Chinese benchmark has now declined by 28 per cent since its mid-June high.
The market collapse underscores a significant slowdown in China that is rippling through the global economy. Trade activity in Asia is declining rapidly. For example, the CPB merchandise: Asia import volume index (the CPB Netherlands Bureau for Economic Policy compiles the most widely used trade benchmarks) has slid 12 per cent so far in 2015. Sluggish trade activity strongly suggests China's gross domestic product growth is slowing, and lends support to those questioning the validity of government reports on the economy.
Now that optimism in mining sectors has all but disappeared, fewer Canadian investors are following what happens in an economy halfway around the world. This is a mistake, in my opinion, and one that could result in Canadian investment portfolios getting blindsided by an economic hard landing in China.
For Canadian investors, the sharp slowdown in Asian import activity has direct implications for domestic resource stocks. Despite the recent dismal performance by the domestic mining and energy sectors – the S&P/TSX diversified mining index is down 15 per cent year-to-date and the energy index is lower by 16 per cent – the commodity complex still forms 29 per cent of the TSX.
Although energy and mining stocks are not dominating the Canadian equity market benchmark as they once did, Canadian stocks as a whole retain a remarkably close association with the China-dominated emerging market equity benchmark.
The accompanying chart highlights that, once currency is accounted for, the S&P/TSX composite has closely tracked the MSCI emerging markets index to an extraordinary degree for the past decade – what happens in emerging markets has been immediately reflected in Canadian equities.
China represents the largest country weighting for the developing world benchmark at 25 per cent of the total. South Korea and Taiwan, both major trading partners for China, make up the second- and third-largest portions of the benchmark.
Commodity prices are the obvious link between China, emerging markets and Canadian stocks. China remains, at least for now, the world's largest importer of virtually every commodity on the planet and commodity prices, along with revenues for domestic miners, are declining along with the country's economic activity. In the coal industry, for example, Chinese imports have declined by 54 per cent since early 2014. The resulting drop in the commodity price has already hit Canadian coal producers hard.
The reasons the Chinese government withdrew support for equity markets overnight remains a mystery at this time. Beginning Monday, the government enacted a host of measures to stop the market slide, including loosening bank credit (by dropping reserve requirements), allowing pension funds to invest 30 per cent of assets into equities, banning selling of stocks by major holders and, perhaps most bizarre, encouraging investors to take out mortgages on their homes to invest in equities.
Commodity stocks aren't the only Canadian shares getting hit by China's decline. Canadian financials, which make up the largest sector weighting in the TSX, are also negatively affected by China's slowdown, although to a lesser degree. The close relationship between the TSX and emerging markets, for instance, will be a hurdle for the rapidly expanding asset management operations of the major banks. A weaker TSX means that bank profits from wealth management are likely to decline. In addition, waning investor interest in mining and energy stocks would result in lower profits from investment banking activity.
Many Canadian investors, particularly those that have thrown in the towel on mining stocks, have stopped following developments in China and the emerging markets, thinking that it doesn't affect them any more. The "China slowdown" story is not new, but the country remains the world's second-largest economy by GDP and a significant slowdown will be felt by every major asset market in the world.
As the chart shows, Canadian investors have a clear stake in Asian equity markets and the potential for a hard economic landing in China – which looks more probable by the day – should be taken seriously.
Scott Barlow, Globe Investor's in-house market strategist, writes exclusively for our subscribers at Inside the Market online. Subscribe to Globe Unlimited at globeandmail.com/globeunlimited.