On Friday August 21, stock markets around the world declined sharply, capping a bad week for shareholders. In Canada the TSX Composite fell nearly 2% on Friday alone, overseas stocks were down nearly 3% and the S&P 500 index of large US stocks dropped by 3.2%.
Before we put this poor performance in context, let’s first address the putative reason for the decline. The Globe and Mail reported on Friday evening that “weak Chinese manufacturing numbers piled onto bad economic news that is now deeply worrying investors,” and the Financial Post reported that “it was an ugly reading on a Chinese manufacturing measure … that hit Canadian stocks particularly hard on Friday.”
Let’s briefly examine the direct impact a slowdown in China’s economic growth might have on either the US or Canadian economies. The charts below show both countries’ exports to and imports from other countries in 2014, expressed as a percentage of total economic output (GDP). (For Canada we show trade in goods only and not trade in services, because the detailed country-level breakdown is not available for the latter. However, trade in services is only about a fifth of total Canadian trade, and it too is dominated by trade with the US.)
Several conclusions can be drawn. First, Canada is significantly more trade-oriented than the US, as exports and imports each represent about 30% of our economy as opposed to a comparable figure of about 15% for our southern neighbor. Secondly, US trade is more dispersed across the world than is Canada’s. No country or region dominates trade with the US whereas the preponderance of Canada’s merchandise trade, roughly 75%, takes place with the US.
Third, and most germane to today’s headlines, is that exports to China are quite small for both countries, only 1% of total GDP. That doesn’t mean that slowing economic growth in China didn’t weigh on investors’ minds this week, or that concern about such a slowdown can’t manifest itself in a global stock market decline. But it does mean any direct impact on both the US and Canadian economies from a slowing Chinese economy will necessarily be very small, and so any large stock market selloff related to this possibility is more a reflection of skittish investor psychology and overreaction than of economic fundamentals.
What about an indirect route, in which a slowing Chinese economy reduces growth in demand for oil, which lowers oil prices further, which may damage the global economy, which causes stocks to drop?
This line of reasoning doesn’t withstand scrutiny. First, the 60% drop in oil prices over the past year resulted mainly from a change in supply - Saudi Arabia’s unwillingness last November to curb its oil production - and not from a change in demand. Secondly, low oil prices are beneficial to most parts of the global economy, particularly the US (a huge net importer of petroleum) and those parts of Canada that are not oil producers. Alberta is a significant exception, and we don’t want to minimize the impact of markedly lower oil prices on Albertans and the Alberta economy. However, to attribute a global stock market decline to an oil price drop caused by supply rather than demand, an oil price drop which negatively affects only a small portion of companies in the global stock market, seems to be vast overreach.
It’s also crucial to keep this week’s stock market decline in perspective. A 6% drop in just a few days seems like nothing to snort at – except that it’s also nothing much out of the ordinary. If we go back not even two years, we observe several dips of similar magnitude. And if we go back further to the start of this century, a 16-year period that includes two vicious 50% peak-to-trough bear markets, we observe a plethora of similar-sized dips even during stock market recoveries.
A 3% single-day drop in stock prices rightly catch investors’ attention. However, with the US economy in robust health, and with China’s direct links with the US and Canadian economies modest at best, the stock market decline of the past few days seems driven more by sentiment than by economic reality. That doesn’t mean sentiment can’t temporarily worsen and share prices can’t fall further in response, but it does mean that a long-term investor shouldn’t be disheartened, frightened or even surprised by this most recent bout of financial market choppiness.
Chief Investment Officer
ATB Investment Management Inc.