Why did CHINA lag the american stock market rally?

While looking at the S&P500 rally in the last few years – compared to the shanghai composite it’s even more impressive. Somehow, even though China is a growing economy and the investment community is very bullish, the stock market actually declined nominally, and if you price it in real prices (with inflation) you get a very grim picture.

So what happened? Why did the USA outperform China for so much time? Why did shanghai composite decline like this?

To understand this we need to understand the starting point. China is indeed a growing economy, one of the biggest manufacturers in the world, a huge exporter.

But over the years the economy of China has become inflated. An economy that grows 8% year over year cannot do it without a big inflation sweep. This inflation process pushes prices of everything up, mostly real-estate assets.

What this means is, while inflation runs – the economy runs and everyone is happy. And while China was aggressively printing money to lower their currency, it actually worked. But changes to the currency flexibility, and giving it the option to gather strength have changed the picture, and turned the tables. The Chinese have decided to let the Yuan rise, and the results are shown below:

Looking at the Chinese currency we see an overall trend of deflation, which means the Yuan goes up, and asset prices go down.

CHINESE YUAN VS US DOLLAR

The effect of deflation, especially on finance, banks and insurance is the biggest.

This means that over time in an inflation-based economy, deflation will slow down the growth, and will push asset prices lower in the short-midterm.  That’s why we see shanghai composite lagging the global rally and declining while the world pushes higher.

Comparison of S&P500 (blue) and Shanghai composite (black)

This phenomenon is already a known one, since Japan’s lost decade, which happened exactly the same way. The Yen strengthened, assets went down and deflated, and the stock market declined.

US dollar declines VS Japanese yen over time

Although japan has grown for years – the stock market didn’t price it because of the strong deflation in the currency. After the real estate bubble crash in 1990, the Nikkei couldn’t go higher for years and years.

To conclude, as China decided to let its currency rise, the price of it was shrinking asset prices. Today the Yuan is stronger, which makes China today much cheaper and more interesting to invest in, although technically speaking the index still looks weak.