What Justifies Record-High U.S. Stock Prices? Maybe China Does

Now that the U.S. economy is showing the strongest signs of growth in years, the most important question for investors is: What happens when the Federal Reserve eases back on its stimulus?

After all, can companies – and stocks – prosper without the central bank’s unprecedented $4 trillion bond-buying program?

The S&P 500 Index and Dow Jones Industrial Average are at all-time highs, yet gross domestic product is growing only 2 percent (after you strip out the inventory growth in the most recent headline number). So it’s hard to make the argument that equities are rising in unison with the improvement in the economy.

So when might economic fundamentals support potentially overblown asset prices?

Enter China. Much of the global growth over the past eight years or so has been fueled by emerging markets and its largest contributor, China.

Click here for larger version

Click here for larger version

As you can see in the chart above, China’s growth has been faster (the steepness of the blue line), and the spread between the U.S. and China has been narrowing rapidly since 2005. More recently, however, China’s growth has been slowing, stemmed by the global recession:

China’s Communist Party leaders finished up their Third Plenum Summit last week. Liberalizing policies to reignite the faltering economy were discussed.
Some of the major reforms include:

1. Relaxing the one-child policy and allowing parents to have two. That would reverse a policy introduced in 1979. Balancing population growth, especially with a large aging population and a shrinking pool of young workers, is key to boosting domestic demand for products and services, and long-term growth.

2. Welfare reforms — allowing citizens who move to keep their welfare benefits regardless of where they migrate to in China. That would allow the free movement of labor and encourage urbanization, which is positive for growth.

3. Land reforms for farmers. They previously had been appropriated land by China with the right to work only on that property. Farmers now would get land rights and be able to collateralize property for loans to invest, grow and cultivate their own business. Again, positive for long-term growth.

4. Reforms on state-owned enterprises. That would include allowing private investments in state-run businesses and mandating that corporations return more (up to 30 percent vs. 15 percent previously) to the state to fund programs.

Click here for larger version

The goal of policy makers is to double GDP from 2010 to 2020. That’s the equivalent of adding a whole other China in six years!

There’s no question that those policies are a step in the right direction. However, the timing and extent of the execution definitely matter, as does the effect on global growth.

Investors welcomed the news and sent China’s stock indexes up 4 percent following the official release.

Regards,

The Money and Markets Team