HARBINGER OR HICCUP?
The steep fall in global equities markets this month has come as a shock to many investors. However it is more the steepness and swiftness of the decline that is surprising rather than the fall itself. Like many, we have been expecting heightened volatility in 2016 — and now we have it. The only question was what would trigger the volatility: China or the Middle East? The US Federal Reserve or the European Central Bank? The key question facing investors now is whether the equity market’s decline is a signal of broader macroeconomic instability, a harbinger of doom. Or just a temporary setback, a normal (if exaggerated) equity market hiccup.
We believe markets are overreacting and that they will recover. The key causes cited for the market’s decline are yuan devaluation, Chinese economic growth, collapsing oil prices and weakening corporate earnings (either in the US because of the strong dollar or in Europe because of emerging market exposure). While there are certainly concerns, they are not significant enough in our view to warrant further dramatic losses in equity markets when developed world economic growth is broadly solid. Let us consider each risk in turn.
The yuan’s depreciation has been unsettling as it followed five years of steady appreciation and certainty that the People’s Bank of China (PBoC) would determine the rate of change. The Chinese yuan was recently included by the International Monetary Fund into the currency reserve basket that makes up the Special Drawing Right (SDR). The PBoC has consequently said the value of the yuan would be driven more by market forces and that they would target the value of the yuan against a basket of currencies instead of the US dollar. As the yuan has depreciated, worries rose of another battle in the “currency wars” of the last several years and that China was deliberately reducing the value of its currency in order to boost the growth of the economy. Predictions of a shock devaluation of up 50% can be seen in the press. Should anything like this occur, the effect on global economies and markets would be severe, both for those emerging market countries whose exports compete with China, for example Korea, but also for those countries which export to China such as Germany.
Predicting the “fair value” of a currency is hazardous at the best of times, but it is all the more difficult when the currency’s value is managed by a central bank and a country’s current account is closed, or at least restricted, as is the case in China. It is nonetheless unlikely that China wants, or that the economy needs, to see a significant depreciation in the yuan. From a macroeconomic point of view, one should expect the yuan to be appreciating versus the dollar, not depreciating, as China still runs a significant trade surplus with the US. The main way this surplus would decline is through Chinese exports becoming more expensive so that the US imports less. It is also unlikely that the Chinese government is attempting to weaken the currency. In fact, they have been trying to prevent its decline by using their substantial foreign currency reserves to support the yuan’s value (reserves have fallen from a nearly USD 4 trillion to USD 3.3 trillion at the end of December).
On the other hand, markets are expecting interest rates to rise in the US but to fall in China, which would argue for a weaker yuan as the interest rate differential narrows. Another factor driving the yuan lower is the flow of capital out of the country as Chinese individuals and corporations try to convert their yuan into dollars in anticipation of further declines in the yuan’s value. This demand for dollars weakens the yuan, generating the exact outcome they fear. It will be necessary that the PBoC is able to stabilise the exchange rate before these capital outflows slow, but it is not clear when this will happen.
Despite the recent announcement of 6.8% GDP growth rate for the last quarter of 2015, doubts persist about both the level and trend rate of growth in the country. Many investors find it difficult to reconcile such a strong growth rate with other figures that suggest many parts of the economy are continuing to struggle (for example, manufacturing PMIs). The primary challenge the government faces is managing the rebalancing of the economy away from investment and towards consumption.
Based on the latest figures, this rebalancing is taking place. The contribution of consumption grew from 4.0% in the third quarter of 2015 to 4.6%, while investment declined from 3.0% to 2.5%. It is worth noting that exports have not been a significant contributor to growth for many years, supporting the argument that a weaker currency is not a goal of the government (see chart).
While we acknowledge the challenges facing the economy, we believe there is enough strength in the “new” China economy (internet commerce, travel, health care, etc.) to offset the weakness in the old (manufacturing and state-owned enterprises). The services sector has surpassed the manufacturing sector in size and should continue to increase as industries like tourism and health care expand.
The main criticism of the economy made by those who are more pessimistic about the country’s outlook is the debt burden, which has risen from 130% to nearly 210% of GDP, according to calculations by Bloomberg. There is certainly a risk that some of these loans will not be repaid, but in contrast to the situation in many other emerging markets, the debt is denominated in local currency and not in US dollars. There is consequently less risk of any defaults sparking a crisis outside of the country. Moreover, the assets of the banks that have loaned this money to the companies are ultimately backed by the Chinese government, which has the resources to stand behind them, in contrast to Ireland or Spain when they faced their own banking crisis.
China will remain a worry for investors and a source of volatility as it is the second largest economy in the world, undergoing a significant transition, and the workings of the economy are opaque. We believe, however, that there is enough opportunity in the new economy for investors, even as we remain wary of those countries and industries which depended on ever rising demand for commodities from China.Download to read more