What Bay Street can expect from China’s chill

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A new rule for the new year: Enough with our denial. China's economy is struggling and its adjustment to a lower gear has the potential to sideswipe us. Find salvation in acceptance.

The best thing anyone can do is expect the worst. History has taught us that even healthy stock-market adjustments are tough to stomach, because such corrections are prone to make us irrational.

Which is why no one should be shocked the year started with such a deep selloff in China, falling 7 per cent before circuit breakers in Shanghai and Shenzhen kicked in. We should wonder instead why it took so long. Investors were all too happy to forget how wild China's markets were in August, naively hoping the underlying picture had improved. The reality: Only heavy government intervention was able to curb the panic.

When the Chinese market started to crater last summer, major shareholders were banned from selling stock; state agencies were handed a few hundred billion dollars to support prices; police barged into investment offices and searched trading records; and a prominent journalist was detained for writing a negative market story.

As for systemic reforms, China installed circuit breakers that are even more aggressive than North America's and implemented a T+1 trade rule, which prevents investors from buying and selling the same shares in one day. Confidence-inspiring, eh?

"To some degree, the prices established in the second half of last year were false prices, because they were not based on people buying and trading shares in the normal way," Arthur Kroeber, managing director at Gavekal Dragonomics, told my colleague Nathan VanderKlippe on Monday. "And if the government support retreats, the false price falls away and the true price arrives – and no one knows what that is."

The information vacuum only amplifies the warning sirens. Nothing is worse for markets than uncertainty, and China's are rife with it. The worst of it? No one knows whether the government's economic data can be trusted. Figures released Friday from China's National Bureau of Statistics showed manufacturing activity shrank for the fifth-straight month in December; a private survey from Caixin/Markit suggests December was actually the 10th-straight month the sector contracted.

Many Chinese retail investors have also been buying shares at breakneck speeds simply because everyone else is, not because they have any idea of whether stocks are cheap. Call it the perfect powder keg.

None of this is good news for Canadian deal flow or market returns, given our markets' overreliance on commodities. No doubt, some pain had already been priced in – before Monday's selloff, the S&P/TSX composite index had already fallen 16 per cent from its 2015 peak – but a volatile Chinese market isn't going to instill much confidence. To add to that, broad investor sentiment already soured here in the second half of last year.

Resource-based companies looking to finance aren't likely to have much luck in this market. Metals investors have been badly burned for years, and their energy-focused peers are now in the same boat. A year ago, there was hope that paying down corporate debt would help to strengthen some of Canada's biggest energy names, but investors who bought shares in the five biggest offerings last year have lost an average of 44 per cent. Safe to say they aren't going to dance if they hear the music again.

The hope is that non-resource sectors will stay strong, because investors have little else to choose. Fingers crossed that proves to be true. Such a heavy rotation into non-resource stocks paved the way for major deals from Emera Inc., Hydro One Inc. and Element Financial Corp.

There's also hope for some mergers-and-acquisition activity. In the mining world, major players such as Glencore PLC and Anglo American PLC have announced asset sales, and sources say independent funds run by former mining executives are lining up as potential buyers. This is the moment they've been waiting for.

Whether independent dealers will be able to advise on any of these transactions is the big question.

So many have been holding on by their fingertips, praying the market turns so they can generate some fees. The fear now is that any advisory work will flow to the biggest investment banks that lent money to buyers and sellers.

Believe me, I'd rather not be the Grinch. Strong markets make for good deals, and covering those is what makes this job fun.

But no one can deny the Chinese economy is chock full of debt, making it a prime candidate for a correction.

Because the country has used state funds to stave off market crashes before, we've come to believe that China's rather immune to bad news. I'd rather be realistic: The recent crackdown on corruption is proof the government knows it's got problems, and that's bound to be true for public markets too.