26th August 2015
Mark Burgess, chief investment officer for Europe, Middle East and Asia and global head of equities at Columbia Threadneedle Investments, says that China is not solely responsible for the economic growth malaise that the world now finds itself in…
It is often said that a week is a long time in politics, but in financial markets a week can feel like an age. On Monday 24 August, global equity markets slumped as the rout in domestic Chinese equities continued, compounding fears that the world’s second-largest economy could slow down much more quickly than had previously been thought. Many investors had hoped that the Chinese authorities would ease policy over the weekend (perhaps by cutting reserve ratio requirements for banks). When this failed to materialise, it added to fears that China’s monetary and fiscal policy is behind the curve. The Chinese authorities then announced interest rate and reserve ratio requirement cuts on Tuesday 25 August, which helped most equity markets to rally, although this soon petered out and the S&P 500 finished down by the closing bell. As I write this, markets remain volatile, and volatility remains elevated by historic standards, as shown by the VIX – Wall Street’s ‘fear index’:
Figure 1: The VIX over the last ten years
Source: Thomson Financial Datastream, August 2015.
As can be seen above, volatility has returned to levels last seen in 2011, when the sovereign debt crisis was in full flow. The question investors must ask now is whether recent events merely represent a correction after a long and strong run for risk assets or something more sinister. It is worth remembering that the equity rally has been driven by a valuation re-rating, rather than earnings growth, and it is this that makes markets vulnerable to the news emanating from China.
Our own view is that equity markets have ridden a wave of QE-driven liquidity in recent years but investors are now facing the reality that developed world economic growth, seven years on from the crisis, remains unimpressive. Policy makers in the US and the UK who would like to raise interest rates are currently unable to do so. In other words, markets had been hoping that the developed world would return to some sort of economic ‘normality’ this year, and in that context a Chinese slowdown could be managed or contained. Unfortunately, the only developed economy of any significance to have registered strong growth post-crisis, the US, has been challenged by a stronger dollar and a tightening labour market, and capital expenditure has been hit by the global slump in oil prices. If the US begins to slow, and China slows quickly or worse, the prognosis for global growth is uninspiring; there are no other economies waiting in the wings to take the economic growth baton despite all the policy initiatives to boost growth, such as QE and 0% interest rates. In that sense, while China was the catalyst for the recent slump in equity markets, it is not solely responsible for the economic growth malaise that the world now finds itself in, and neither is it responsible for the fact that the policy toolbox in the developed world is empty.
What does this mean for investors? If the recent stock market falls are merely a correction, there will be good opportunities for long-term investors, and my equity colleagues from the across the floor have been adding to their favoured holdings at attractive valuation levels. This has had to be done with care, however, as some of the intra-day moves have been large. In bond markets, we have been struck by how little diversification core government bonds have provided: they offered some resilience on Monday but were routed on Tuesday. We have been underweight core government bonds and we are not inclined to change that positioning given how they have performed. On the policy front, we think it is now unlikely that the Bank of England will raise interest rates this year. In the US, market pricing suggests that the odds of a Fed rate rise this year are evenly balanced, but we think that the likelihood of a Fed rate rise in 2015 is fading rapidly. Indeed, irrespective of what happens in China, a ‘lower for longer’ interest rate environment now looks likely.
Taking everything together, our initial assessment is that this is a correction rather than the beginning of something bigger, although a great deal depends on what happens in China over the remainder of this year and into 2016. For that reason, we are doing a lot of work on what the global impact of different rates of Chinese economic growth would be. If authorities there can achieve a ‘muddle through’ scenario, then there is a good chance that the developed world will be able to do the same, and in that event the current slump could turn out to be a buying opportunity. However, if the Chinese authorities cannot steady the ship, the outlook for global growth is lacklustre. Delayed interest rate rises would be positive for equities (and emerging markets) in the short term and would help to support bond markets. However, in the longer term, the inability of central banks to raise rates modestly would be indicative of a very weak growth environment, which ultimately would be bad for stocks. A world in which China exports deflation would be very challenging for corporate profits globally as pricing power is likely to be eroded. In that scenario, we would have to focus on secular growth (where it can be found), industries with high barriers to entry, and self-help stories.