24th August 2015
David Jane, co-manager of Miton’s multi-asset fund range, looks the turmoil in China and examines the parallels with financial market history…
The state of the economy in China has troubled investors for some many years now, reflecting its importance to the global economy, both during its emerging growth phase and now during its maturing phase. There are some parallels between China’s current situation and financial market history which shed some light on current events.
Two historical phases spring immediately to mind and both are from Asia, Japan’s stock market bubble and the Asian currency crisis. Perhaps we have parallels with both simultaneously. When Japan’s economy reached its plateau at the end of the 1980’s there was a vast excess of domestic savings and a rapidly ageing workforce. This led to an asset price bubble and, ultimately, a long drawn out period of deflation. China is clearly entering a similar phase as its population matures, although it can be argued that further growth can be achieved through internal migration from rural areas to the cities, if barriers are reduced.
The Asian currency crisis in the late 1990’s was caused by pegged exchange rates and an excess of foreign currency debt. Pegs were broken leading to a banking crisis. China has a peg and certain sectors are known to have borrowed heavily in dollars. The difference is that China has strong control over its exchange rate and stronger government finances than those involved in the Asian crisis.
In conclusion, there are parallels and differences in that we are dealing with a maturing economy with an asset price bubble and a currency peg, but one which has strong control over capital markets and high external reserves. Additionally, this crisis is taking place in the post Global Financial Crisis era of widespread financial market intervention.
External financial markets’ problems when considering China are exaggerated by a lack of transparency in any data, leading to unhealthy speculation and a high degree of government involvement in local financial markets. This can potentially lead to some troublesome feedback loops exaggerating perceived problems and these are often a feature of financial crises. A case in point with China might be commodity markets which are notoriously thinly traded. Economists often look to movements in metals and other commodities for evidence of Chinese economic activity, whereas metals traders look to economists’ forecasts of Chinese economic activity to forecast demand. This feedback was self-feeding in the boom times and is now working in reverse. A dispassionate analysis might suggest that global oversupply from huge capacity investments in the boom years will take many years to work through the system and that commodities are falling for this reason, not that China is somehow growing dramatically slower than the figures suggest.
The shock from China is now being felt throughout the region as other currencies weaken in response to China’s devaluation. We have for a long time been cynical about many of the region’s governments, particularly Malaysia, where their new found status as low yielding borrowers on international markets seems completely unjustified by their precarious government finances and dependence on resources.
What are the implications for broader economies and financial markets? From an economic point of view cheaper commodities and cheaper Chinese imports are disinflationary and therefore might be seen as broadly positive for western economies. The degree to which this is partially offset by the negative of reduced Chinese demand for Western capital goods and luxury goods is unclear. On balance we should expect low inflation and stronger real income growth in the West.
The end of the Japanese bubble was largely unnoticed in Western economies except at the margins, whereas the Asian currency crisis led to a short term equity market correction prior to the end of the 1990’s tech bubble. In the current case China’s financial markets are not especially integrated with those of the West, unlike those of Southeast Asia, so we might expect its problems to effect developed markets much less than those of Asia despite them being on a much greater scale. However, economies around the region are very dependent on China and we are already seeing these effects from Japanese exporters through to Singaporean property as reduced Chinese demand feeds through those economies.
Recent portfolio activity has included some sales of our Japanese exporting exposure, leading to an overall reduction in Japan, and complete sales of our emerging market bond exposure. We continue to take the view that interest rates will peak at a lower level and rise more slowly than the market expects, so feel comfortable with our developed market credit exposure. In summary, while we cannot be sure that current events in China and Asia will not have a negative knock on effect more widely in financial markets, we are at least confident we are not exposed to the first and second order effects and that our high cash weighting gives us flexibility to take advantage of opportunities when they arise.