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By: Simon Danaher

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August 28th, 2015

China market crash: An idiots’ guide to Black Monday

Financial Education

What caused markets to plummet and what you can learn from it

This week saw some of the biggest single-day stock market losses since the Global Financial Crisis in 2008. Monday saw the brunt of the decline, with China’s Shanghai Composite Index losing a massive 8.5% during the day’s trading.

china market crashThe China market crash, dubbed “Black Monday”, was echoed by other markets around the world, with the UK’s FTSE 100 and S&P 500 in the US both seeing significant falls over the day.

These losses have now been largely made up, with the S&P 500 on Wednesday chalking up its biggest daily gain in four years and giving the FTSE 100 a boost.

What caused the crash in the first place?

First, it is worth pointing out that, while Monday’s losses were big and their speed surprising, the Shanghai Composite Index has in fact been steadily losing value since June, falling around 40% in the past three months. This makes the speed of Monday’s losses, and the wider market reaction, perhaps even more surprising.

Stock markets are extremely complex beasts and understanding exactly why they behave the way they do is almost impossible. Everything from economic policies to investor sentiment plays a part in dictating share prices. What we can do though, is explain factors which may be influencing investor behaviour at any one time.

The economy

One of the biggest concerns is that China’s economy – long an engine of regional and global growth – is slowing. For the past three decades, China has churned out growth averaging 10% per year. Last year however, it fell to 7.4% and growth for this year is forecast to be around 6% or 7%.

One of the reasons for this slowdown, is a decision by the ruling Communist Party to begin a transition from a heavily manufacturing and export led economy, to one which is more reliant on domestic consumption and service sectors. The consequence of this is that its consumption of things like raw materials will fall.

Fears of a continued slowdown in economic growth could perhaps have sparked the rout we saw on Monday, with concerned domestic investors selling down positions. Another point here is that the actual effect of share price slides in China itself has little direct material impact outside the country, as only 2% of shares are owned by foreign investors.

What is of bigger concern is what the market crash indicates to the outside world. Investors in the US, the UK and elsewhere could have simply been spooked by the market crash in Shanghai, leading to the losses on other stock markets.

Another factor which may concern investors about the Chinese economy is that it has been buoyed by substantial government investment, which in turn has created artificial support for shares. 

Since the Global Financial Crisis of 2007/2008, the Chinese central bank – the People’s Bank of China (PBOC) – has pumped hundreds of billions of dollars into its own economy. This investment, which includes huge spending on sectors such as infrastructure and technology, stemmed off the recession suffered in most countries around the world, and helped guarantee continued growth. China’s program of monetary policy easing is similar to the programme of quantitative easing western central banks engaged in.

Although China isn’t directly purchasing assets, as has been the approach adopted by other central banks, by pumping money into an economy, the central bank is providing artificial support, which investors know must end at some point.

It is also fair to suggest that, by doing this, shares became overpriced. The QE programme could also have therefore been a factor in Monday’s crash and the losses seen since June.

Fluctuating currency

Another factor which has potentially spooked markets is China’s decision to devalue its currency, the remninbi, in August. The remninbi loosely tracks the American dollar (investors call the dollar the “greenback”) and so had been rising steadily for some time, as the US economy continues to power ahead. This was making exports increasingly expensive (which means they are less competitive globally) and so the central bank, the PBOC, took action and devalued its currency.

At the time, China said it wanted a more “freely traded currency” – essentially one which was less tightly controlled by government. The decision to allow its currency to fluctuate may be to please the International Monetary Fund in order to have the renminbi added to the basket of globally accepted reserve currencies.

Since the devaluation and with the government having a much looser grip on the currency, the remninbi’s valuation has fluctuated wildly, which causes problems and uncertainties in itself. However, the real worry is that the devaluation could export deflationary pressures elsewhere in the world, which would of course dampen markets.

Falling oil prices

Oil prices are at their lowest levels since stock markets hit a “bottom” in March 2009, following the Global Financial Crisis. They have also been low for a sustained period of time, having begun decreasing in value last summer.

There are a number of factors driving these low prices. These include: a glut of supply from oil producing countries in the Middle East, an easing of relations between the US and Iran – also an exporter of oil – and, most importantly, the boom of so-called “fracking” in the US. This last factor is perhaps the most important.

The US is the world’s largest consumer of oil and used to import huge quantities from countries like Saudi Arabia – which in turn helped keep prices afloat. However, the boom in hydraulic fracturing, or “fracking”, has significantly cut America’s reliance on imported oil and contributed to the sustained fall in the oil price.

This is a long term story and so does not explain why the market reacted so badly on Monday. However, it is something which will be on investors’ minds.

A US interest rate hike

The American central bank – the Federal Reserve – has been indicating for some time that it will increase the US interest rate, which has been at almost zero for more than seven years. Earlier this year, the Fed indicated the hike could come in September – although after this week’s volatility it is very likely that this date will be pushed back.

But why does this matter and what on Earth have US interest rates got to do with China?

Generally speaking, stock markets don’t like interest rate increases. They don’t like them because when interest rates are increased, the cost of borrowing goes up. When the cost of borrowing goes up, growth can slow because people and companies with debt have to spend more paying that debt back and so have less money to consume goods.

This is a broad generalisation, but important. The US is still the world’s largest economy and its currency and interest rate therefore are still very important and have a huge influence on the economies of other countries. In short, the roots of American financial influence are spread far and deep in the global economy.

However, an interest rate rise has been clearly flagged by the Fed for some time and should therefore not be of major concern to investors.

What can we learn from “Black Monday”?

Something which never fails to amaze me is the number of people who sell at times like this. The actual crash of a stock market, regardless of the underlying cause, is simply people clamouring to sell, often in a blind panic.

There have been countless stories on the news over the past week about Chinese investors who have lost thousands and, having seen the value of their money collapse, have sold their shares.

This is exactly how you SHOULD NOT run your investment portfolio. Arguably you should try to buy when a market falls, but this is hard to do, and can be hard to stomach for most investors. If this is something you would like to do, here are three funds we think are a good buy right now.

What this episode and these tragic investors’ stories do highlight is the importance of investing for the long term, having a plan and understanding exactly how much risk you can afford to take.

To find out more about how to take advantage of opportunities like these or for help building an investment plan, click the link below.

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About Simon Danaher

Simon Danaher previously worked for AES International, in marketing and communications.