Market Update for March 14, 2014

We were expecting the markets to begin pricing in the current risks associated with China and Ukraine. The move occurred on Thursday, as the Dow Jones Industrial average fell 1.4 percent, the S&P 500 fell 1.2 percent and the NASDAQ fell 1.5 percent.

Most of the economic data in the U.S. was strong, with jobless claims coming in below expectations. The U.S. remains mired in a weak recovery though, and with emerging markets weakening the past couple of years (and especially since the Fed announced the taper in May 2013), China is the last remaining engine pulling the global economy forward. If China weakens, demand for many imports such as commodities could collapse due to massive Chinese stockpiling of resources.

The risk from China is also great because the economy is in the midst of rebalancing. This week the head of the central bank said interest rates will be fully liberalized in one to two years. Right now we’d speculate this change will be on the early side as financial innovation is occurring at a rapid pace in China. The Chinese equivalents of Ebay, Amazon and Twitter are now in the banking business, offering money markets to users with much higher interest rates than banks. Banks themselves offer various high-yield products to investors as well, but last year less than 50 percent of new loans came from the traditional banking system. Private banks are also being opened by some of these same firms, and they are working on online banking as well as virtual credit cards.

These structural changes illustrate the Chinese economy has entered another stage of reform. Even if there is no crisis in China, there very likely will be a slowdown due to the fall in investment and the rise in consumption. A crisis is possible during this transition phase, but crisis or not, Chinese demand will shift away from imported resources and towards imported and domestically produced consumer goods and services.

Investors wanting to keep an eye on the situation can look to copper, oil and the exchange rate of the Chinese yuan, which fell again today. Gold is likely to do well in a crisis because weakness in China leads to a lower yuan, which results in higher gold prices. It is much easier for Chinese to buy gold than it is to buy U.S. dollars, so as long as gold can remain flat or rise, Chinese buying is likely to continue. It may even accelerate in a crisis situation as Chinese look to hedge against yuan weakness.

Domestically, the leading sectors such as solar, biotechnology and social media took big hits during Thursday’s sell-off. That’s normal for these volatile funds, but these funds bear close watching because they will give an early signal as to whether this sell-off will continue or whether the sell-off yesterday was an isolated short-term event.

The U.S. can plod along fine if global markets cooperate. The drop in copper this week sends a warning that they may not. If the metal can climb above $3, its long-term support level, markets will reverse along with it. If it struggles to rally, it will be a cloud over the market. Its weakness may not be enough to damage the bull market, but it could slow market gains in the coming weeks.

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