Sentiment not backed by fundamentals
Fear about US monetary policy and China’s economic slowdown is affecting global financial markets.
Edward Smith, Asset Allocation Strategist
We think the poor start for equities this year has been driven by fear rather than economic fundamentals. This has been a financial correction, not an economic one: the probability of a recession in developed markets in the next four months currently implied by the macroeconomic data is very low. This is no succour to investors whose portfolios may have dipped sharply over recent months; however, a financial crash – in the West or China – appears unlikely.
We expected markets to become volatile as the US started to raise rates. And they have, but we reiterate that policy tightening is not a problem while a healthy gap between growth and interest rates (or the return on capital and the cost of capital) remains.
Economic data continues to surprise on the upside in Europe and Japan. Across the Western hemisphere non-manufacturing PMIs are firmly in positive territory. Six of eight developed market services PMIs are above 55, up from three last quarters. This is far from an Armageddon scenario. Disappointing US manufacturing ISM data should be taken in context: the sector accounts for just 15% of GDP; services is the main driver of Western economies and in the US that ISM is at a healthy 55.3.
Recently, markets have become obsessed with Chinese data and stock market performance. We think this focus is misguided. China’s equity market is notoriously fickle, driven as it is by retail investors. Still, only a small proportion of households dabble in the stock market, which should prevent any market crash from contaminating the real economy. There is no correlation between consumption spending and stock market returns, financial interlinkages are small and companies are not reliant on equity market capital to the same degree as Western counterparts.
An economy on the move
China is moving from an economy led by manufacturing and construction to one being driven by services and private enterprises. These segments of the economy make up more than half of China’s output and continue to grow strongly. The old, heavily industrial China is in a severe slump, one that is likely to get worse before it gets better as policymakers accelerate restructuring in 2016.
Remember, the overall rate of growth in the economy has already halved over the last five years and the world has not fallen apart. The January trade data release shows the volume of Chinese exports increased in December, helped by the currency devaluation since August. Importantly, there were also signs of improving domestic demand: import volumes grew by approximately 7% in 2015. Further evidence that the turmoil of the markets in no way reflects the economic trends.
China’s leaders bungled their attempts to support the stock market; the now-abandoned ‘circuit-breakers’ arguably making the falls worse. Those effects rippled out to global markets and stoked fear in investors. The falling renminbi spooked investors further, but, again, this is about poor communication by the People’s Bank of China (the central bank) rather than an indication of panic. In December it said it was moving toward abandoning ties to the dollar in favour of a trade-weighted float.
It seems that they are actioning that plan much quicker than first indicated. This month, the central bank’s chief economist confirmed this was the case in the China Daily newspaper. If the policy change had been set out more plainly in advance, the market would probably have been much more sanguine – it’s eminently sensible, after all.
Currencies in the spotlight
This is far more another dollar appreciation story than a renminbi depreciation story. The Chinese central bank is spending foreign exchange reserves in record amounts to stop its currency from falling too quickly against the dollar, not engage in ‘competitive devaluation’. Progress towards a free floating renminbi is part of making China a market-based economy.
Private capital outflows are concerning (especially as the borders are supposed to be closed to these money flows), but at the moment they can be attributed largely to three factors. The repayment of dollar-denominated loans by industrial and commodity giants and property developers; cross-border mergers and acquisitions; and hedging activity on expectations of further renminbi falls. Only the last of these is problematic.
The renminbi is likely to continue its devaluation as it remains about 1.5 standard deviations overvalued, down from 2 standard deviations last summer. We expect a gradual depreciation against the dollar to continue, while the renminbi should stabilise around other currencies, according to the PBoC. Historic context may offer some solace: no modern country has suffered a currency crisis while holding such a large current account surplus. This is because a healthy current account shows a nation is not reliant on foreign investment.
We remain vigilant for signs of deterioration in China. We would escalate the probability of a ‘hard landing’ if we see a combination of:
- a marked deterioration in service-sector PMI and other related data
- private sector profit growth starts to recede
- further acceleration of capital outflows
- banking sector trouble (this would likely be anecdotal, as the data will be obfuscated).
Political theorists suggest that nations and their economies are stable when they are either authoritarian, consolidated and closed; or democratic, stable and open. Turbulence tends to occur in-between these two states. China is just now emerging from the former and we should expect turbulence to continue for many years. As long-term investors, we need to assess what are just bumps in the road and what represent a material deterioration of economic conditions.