China - can the cracks be repaired?

Posted by Liz Rees in Market commentaries category on 26 Aug 15

Why have stock markets fallen so much?

  • The sharp correction in global markets over recent days is a knee-jerk reaction to an unexpected move by the PBOC (Peoples Bank of China) to devalue their currency- the Yuan- in an attempt to boost competitiveness and stem the slowdown in the Chinese economy.
  • While the economic data has been deteriorating for some time, the latest figures showed manufacturing experiencing the biggest contraction for 6 years and exports dipping 8.3% in July. However, to put this into context GDP growth was previously expected to be 7% and even if it falls short of this it is a figure far higher than in most countries.
  • China has now relinquished all of its 2015 gains, having fallen nearly 36% from the beginning of June, in local currency terms.
Which areas are worst affected?

  • Asian markets with close trading links to China retreated sharply. Japan also reported a setback in economic recovery with GDP declining 1.6% year on year in the second quarter after expansion of 4.5% in the previous quarter. The government is expected to revise down growth and inflation forecasts in October and may decide on further monetary stimulus.
  • Oil and commodity prices, of which China has been a leading importer, dropped sharply affecting companies with activities in these sectors several of which are components of the FTSE 100 index. This exposure to miners and oil exploration along with other businesses which have significant exports to Emerging Markets has lead to greater falls in the leading Blue Chip Index than the rest of the UK market which is more domestically focused.
Should I be concerned?

  • China is the world’s second largest economy and accounts for 15% of global output and there will be few countries it does not trade with. Falls in raw material prices, whilst good news for manufacturers around the globe, has fuelled fears of deflation in developed economies such as the UK and Europe where inflation is already running at subnormal levels.
  • However, the news is not all gloomy. Recent events make an early interest rate hike in the US and the UK look less likely which lead to a rally in fixed interest stocks and bonds and would also be supportive for consumer spending.
  • The CBI (Confederation of British Industry) has actually raised its forecasts for the UK to 2.6% for 2015 and 2.8% for 2016 due to a combination of stronger household spending, higher wages, low inflation and increased investment. Furthermore, Europe and the US have generally seen a reasonable corporate results season.
  • China is in a transition phase as the economy moves from one focused on exports and infrastructure to a more consumer driven economy supplying a rapidly growing middle-class population. This should provide great opportunities in the longer term for other countries, including our own, to grow exports to China.
What action has been taken?

  • An initial injection of billions of Yuan failed to support the market so now the State Council has now given the go-ahead for the country’s huge pension fund to invest up to 30% in equities- it was previously confined to bank deposits and treasury notes.
  • On 25th August the PBOC cut its main interest rate by 0.25% to 4.6% in an attempt to boost the economy and further stimulus can be expected. The government is also intervening to prevent further devaluation of the currency.
Are there more falls to come?

  • We cannot be certain that markets will not face further setbacks if the world economy slows. However, some commentators have suggested that recent falls have been exacerbated due to the greater amount of algorithmic (computer based) trading that is taking place. Moreover, many professional fund managers who would normally buy on the dips are away from their desks on holiday.
  • Another point to remember is that although the Chinese economy is a substantial part of the global economy, its stock market is a much smaller part of world markets* and has more activity from private investors and speculators rather than institutions which explains the greater volatility. After ‘Black Monday’ indiscriminate falls on 24th August, while Shanghai’s decline continued most other markets have managed to decouple and refocus on their own outlook and prospects.
What should I do?

  • In conclusion, increased volatility, after a lengthy bull run in equities assisted partly by quantitative easing programmes (which tend to drive all assets higher), is unsurprising and long term investors may actually see it as an opportunity to buy into the setbacks.
  • Panic selling can mean you risk getting out at the bottom of the market or failing to getting back in before markets rally which can be very quickly when professional traders start buying again.
  • Cautious investors may wish to consider ‘target absolute return’ funds which aim to deliver gains (or minimal downside) in all market conditions.
  • As it is very difficult if not impossible to determine a turning point a sensible strategy may be to drip feed any available cash into the market on a regular basis. In the words of the world’s most renowned investor, Warren Buffet: ‘Be fearful when others are greedy and greedy when others are fearful.’
*This is due to restrictions on shareholdings by foreign investors.

Important Information: We do not give investment advice so you will need to decide if an investment is suitable for you. If you are unsure whether to invest, you should contact a financial adviser

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