Why Chinese Market Pullback Could Be Good for US Stocks

Though the stock market trembled over the past week partly on worries that the Chinese government is putting the reins on growth, a decline there could present an opportunity for US investors.

Chinese Yuan note
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China has raised the level of capital ratios banks must keep on hand, a move that inhibits lending and could slow down an economy that grew at a 10.7 percent clip in the fourth quarter of 2009.

Analysts have seen the move as integral to the slump in the US stock market this week as investors worried that a slowdown in China would affect global growth.

Such thinking, though, ignores the opportunity that a slowdown in Chinese markets could present for the US market.

"You think of China the way we think of a growth stock, and think of the US the way we think of a value stock. Investing is a relative world," says Mike O'Rourke, chief market strategist at BTIG in New York. "If investors do get concerned about China and want to do some profit-taking, I wouldn't be surprised if that money flows into US equities."

As its government seeks to control inflation, the Chinese market is among the worst performers on the global stage, with stocks off 14 percent from their most recent highs.

Few expect the trouble to last.

The Chinese economy grew 8.7 percent in 2009 and is likely to continue doing so this year. But the government's efforts to show the world that it is attending to inflation concerns, albeit in a fairly unconventional way, indicates a momentary pause in the Chinese markets is likely.

Investment strategists see a strong possibility investors who have been piling money into emerging market funds might rotate back into broad-based US stock plays.

"There's not really a scenario where the US could outgrow China," says Brian Nick, investment strategist at Barclays Wealth in New York. "But the more of these announcements from China, China as an investment opportunity becomes less attractive because you just don't know what they're going to do."

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Indeed, instability has rattled the market all week, not merely from China but also from Washington, where policy makers have taken a series of aggressive measures aimed at punishing Wall Street's biggest names.

Adding the always unpredictable Chinese government into the mix is a recipe for precisely what happened in the US market—an aggressive selloff that could well be reversed but nevertheless has raised the specter of a long-overdue correction.

"When you look at the market selling off, the assumption is that's it, they've put on the brakes, there's no more lending. And that isn't realistic either," says Quincy Krosby, market strategist for Prudential Financial in Newark, NJ. "The Chinese have to weigh social issues with growth, and it suggests that obviously they're going to be concerned with inflationary pressures. But it doesn't behoove the Chinese government to just stop all commerce at this stage."

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The tightening move, Krosby adds, could well be window-dressing aimed to present at least the appearance of slowing down and bringing a somewhat convenient drop in asset values. Commodities, for instance, have also fallen during the US market's decline, and China needs lower oil prices to help it grow.

As that trend transpires—ahead of an expected round of tightening around the world—investors in US markets could have a window of opportunity.

"The implications are positive for US markets right now with global interest rates still close to record lows," says John Stoltzfus, senior market strategist at Ticonderoga Securities in New York. "The prospects for rising rates could cause investors in maturities with current yields (to find) some opportunities for US markets to outperform."

"For how the secular story belongs to the emerging markets, in the near-term basis it gives the chance for US markets to shine," he adds.

At the same time, there needn't be worries about the Chinese markets showing any drastic declines and ultimately leading world markets lower over the long term, Stoltzfus says.

"With investment in technology that's occurring in China, it would look like growth is fairly well entrenched," he says. "It just needs to be managed, and the Chinese monetary authorities are quite willing to manage it."

Nevertheless, US stocks are on a three-day losing streak, the worst the domestic market has performed since October. Investors remain unconvinced about the strength of the 10-month rally, with inflows to bond funds still outpacing equity funds in January.

Anytime there's talk about slow growth for an economy like China's that is poised to overtake Japan as the second-largest in the world behind the US, investors are going to get nervous.

"If you slow growth too much, you raise interest rates too much, the other economies are going to suffer, too," says Peter Cardillo, chief economist for Avalon Partners in New York. "One of the reasons stock markets have been outperforming is because of cheap money. When you curb that risk factor by raising rates that may not be all that positive in the short term."

Of course, a pullback from a 60 percent gain has been expected for months, so the market taking a pause while it digests the news from China and at home isn't cause yet for much alarm among strategists.

"Overall, investors are being hit by uncertainty in every which way," Krosby says. "With that said it's very healthy to see this market pull back, just take a breather and wait for more concrete information."