The major US equity indices experienced a bungee jump this week after market analysts were forecasting a correction over the last few weeks. Seasoned Alarmists like Peter Schiff et al have been warning for years that the current bull market was artificially created by the Federal Reserve. But, this week's sudden decline even prompted mainstream economists to express their concern about the viability of the post-2008 economic recovery of the US economy.
There were several factors that led the investors to lose their confidence and each of these concerns has to be addressed fully before we will see the market settling down and resume the uptrend.
China Has Reached the Tipping Point of its Growth Model
Anyone remember the Asian Financial Crisis and why the Newly Industrialized Economies (NIEs) could not handle the crisis triggered by Thailand in the 1990s?
Just to refresh our memories, most of these Asian economies were experiencing "production based growth" or picking the low hanging fruits. Their economies scaled up to a point where adding further capacity negatively affected the output. This is similar to the concept of diseconomies of scale.
China has been pursuing a similar production based growth model. For years, we knew they have built cities after cities in order to meet the GDP target. Oh yes, unlike free market economies, where growth is organic, in the command economy hell of China, you can apparently "create" growth.
The situation has reached a point where central planners wanted to build 50 Boston size cities by 2020. However, at this point, creating capacity in the economy is actually (finally) negatively affecting their economy as vital resources are pulled from where they are needed to build roads and buildings in places, where there is no demand.
Then, the Chinese stock market, including the Shanghai composite, skyrocketed to a point where it was simply not sustainable. It was a "black swan" event for the Chinese investors to see the price of their real estate investments plummeting and the artificial stock index reading finally took a dive. It would have been a major surprise to 6% of the investors, who had to rely on a third person to read the news since they cannot read.
In the coming years, China has to find a way to improve the productivity of their workers and increase per capita output without simply investing in capacity building projects. Sorry, but just building roads and bridges won't simply allow the Chinese government to deliver double digit growth in this century.
The US Economy is Overheated to a Certain Extent
Thanks to the socialist from Vermont, Bernie Sanders, there were some structural changes in the US financial industry after the market took a nosedive after the housing bubble went off. However, the Federal Reserve to some extent has created a bigger bubble by keeping interest rates near 0% for too long.
The US equity market has been growing for last six years with few minor corrections and it was about time that we had a correction.
The Federal Reserve has been talking about hiking rates for last 12-months but failed to deliver on their promise. They were scheduled to hike rates after Q2'15 and that created concern among investors.
The US Congressional Budget Office (CBO) estimates that the non-accelerating inflation rate of unemployment (NAIRU) is currently around 5.2%. The US Bureau of Labor Statistics officially said that in July 2015, the unemployment rate in the US has fallen to 5.3%.
It means that companies are having difficulty finding "workers" in the US right now to fill their open positions. Top tech companies had this problem to a certain extent that major companies were asking for immigration reform to bring more programmers in the US. Now, fast food companies are also facing difficulty finding workers. Forget about the minimum wage increase, many US companies are voluntarily paying more to their workers just to retain them.
The US economy was clearly showing the signs of overheating and the prospects of an overnight interest rate hike were already there. The crash in China only triggered this fear factor that the fragile US economy can't sustain the rate hike.
According to George Osborne, the UK chancellor, the issues in China won't affect European economies. The Federal Reserve was trying to float this concept for the last several weeks as well, that US won't be affected.
The issue with globalization is that it acts like leverage, and can cut both ways. It gives our companies the edge of a larger global market to scale and bring prosperity home, but it also synchronizes the global problems. Hence, the US economy is not immune to the bad policies of the Chinese central government just like the Chinese workers are not immune to the reckless home buying binge in the US real estate market.
Commenting on the Monday crash, Lawrence Summers Tweeted that "as in August 1997, 1998, 2007 and 2008 we could be in the early stage of a very serious situation." He might be right, as this issue is not simply correlated to the Chinese market. The crash in China only triggered it. Unless the problems of these underlying fundamentals are addressed, the symptoms are simply not going away.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.