This article was written by Invesco PowerShares Senior Equity Product Strategist Nick Kalivas.

The Chinese equity market has declined sharply over the past month, with the Shanghai Composite Index off 34.9% from its June 12 high to a July 9 low.1 This decline is on par with the 1987 US stock market crash, but has yet to reach the depths of the 2007 sell-off in China or the US financial crisis of 2007 and 2008. The steep drop has touched off fears that the Chinese economy will suffer an adverse wealth effect and a material slowdown in growth — and we’re already seeing signs of such a slowdown:

  • Audi recently indicated it was abandoning its Chinese sales target, noting weaker demand, while Jaguar Land Rover cut prices and its sales target due to slowing demand. 1
  • Bloomberg ran a story on July 16 highlighting forced real estate sales to meet margin calls. A broker from Centaline Group was quoted as saying the stock market decline had delayed or terminated home purchases.1
  • Chinese consumers are leveraged to the equity market. Margin debt outstanding is elevated at 918 billion yuan. That is about double last year’s level and is putting pressure on consumer balance sheets.1 How does it get repaid?
  • Income growth and the Chinese labor market are both softening. Per-capita disposable income expanded 4.75% on a year-over-year basis in the second quarter — well below China’s 10-year average of 11.5% — while the ratio of jobs-to-applicants declined to 1.06 in June, down from a peak of 1.15 in December 2014.1

Does China matter?

According to the International Monetary Fund, China is the world’s third largest economy by region, accounting for 15% of global gross domestic product (GDP). By comparison, the Unites States and the European Union represent 24% and 22% of global GDP, respectively.2 Moreover, China’s economic growth has consistently outpaced growth rates in the developed world. In fact, since 2010, China’s economy has grown 3.8 times faster than that of the US.1 China’s significant contribution to global economic growth indicates that a material slowdown could adversely affect the global economy and corporate profit outlooks.

What does history say about stock market crashes?

Signs of slower demand beg the question: Do large stock market declines lead to slower economic growth? To explore this question, I looked at five major stock market sell-offs and ensuing industrial production trends measured on a year-over-year basis.

The table below shows three major stock indexes that saw major sell-offs since 1987. Also shown are the beginning and ending months of the sell-offs, the durations, percentage change in index returns, and year-over-year industrial production growth during the following year.

The graphic below further displays the trend in industrial production growth following each index’s peak.

Industrial Production Growth as a Percent of the Stock Market Peak Month

What market crashes tell us about industrial output

The numbers above show that stock market crashes have had varying impacts on industrial output, but there are some conclusions we can draw.

  • In the year following a major stock market peak, industrial production growth declined by an average of 125%.
  • This figure was skewed markedly lower by the US stock market crashes of 2000 and 2007, but in both cases US industrial production went from positive to negative growth. US industrial production contracted 4.2% and 6.9% a year after the 2000 and 2007 declines, respectively. These were substantial contractions.
  • Growth in industrial production dropped after four of the five market crashes, with Japan’s crash in 1989 the lone exception. In that case, Japan’s production actually increased, suggesting the stock crash had limited impact on output. It should also be noted that China’s growth rate slowed dramatically from 2007 to 2008, falling over 50% from 17.9% to 8.2%, but came down from a very high level.
  • The contractions in US output occurred in periods when there was an extended sell-off. The duration of the declines after the 2002 and 2007 stock market peaks lasted 25 months and 16 months, respectively. By contrast, the US stock market stabilized three months after the 1987 crash. This indicates that there may be a relationship to the length of a stock market sell-off and its impact on the economy.
  • There were large stock market declines in Japan and China, but they did not lead to a contraction in industrial output a year later.

The heavy use of leverage and public participation in the current Chinese stock market is analogous to circumstances in the US during the late-1990s technology bubble. It’s questionable that China’s current situation can be directly compared to the US tech bubble for cultural and economic reasons; one is a developed country, and one is an emerging market. But the persistent actions by the Chinese government to prop up the equity market and control the decline suggest that officials there see material risks. Despite the apparent risks, the US equity market is pricing limited risk from China. This is evident in the CBOE Volatility Index — a barometer of near-term market volatility — which is flirting with spring lows below 12.1

An investment option for overseas market turbulence

The Shanghai Composite Index has so far been able to remain above former highs in the neighborhood of 3,400 established in January 2015 and in late 2009.1 But it’s still too early to say that the meltdown is over, given high margin debt and the struggling Chinese economy. If history is a guide, investors should be aware of the risks to global growth that the continued sell-off in Chinese stocks represents. In my view, global economic growth seems more likely to slow than accelerate, and China represents a new obstacle for equity investors.

After consulting with an advisor, investors looking to navigate the risks created by the Chinese stock market sell-off may wish to explore low-volatility investing. The PowerShares Emerging Markets Low Volatility Portfolio (EELV) has just 3.3% exposure to China.3 Given the importance of the Chinese economy to global growth and its potential impact on the US economy, US investors may also want to investigate low-volatility investing through the PowerShares S&P 500 Low Volatility Portfolio (SPLV).

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