15th January 2016
Investors may be concerned about the temperamental stockmarkets but they should as a poor start for equities has been driven by fear not fact.
Edward Smith, asset allocation strategist at Rathbones, said equities have had a bad start to the year but this is down to investor fear rather than economic fundamentals.
He believes there are five reasons why investors should keep faith in markets.
1. A financial correction
The state of equities at the moment is ‘a financial correction, not an economic one’, he said.
‘The probability of a recession in development markets in the next four months currently implied by the macroeconomic data is very low,’ he said. ‘An economic crash – in the west or China – appears unlikely.’
Markets were expected to become volatile as the US raises rates and they have but Smith reiterated 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’.
2. Economic data still positive
The economic data coming from Europe and Japan is still continuing to surprise on the upside.
‘Across the western hemisphere non-manufacturing PMIs are firmly in positive territory,’ said Smith.
‘Six of eight developed market services PMIs are above 55, up from three last quarter. This is far from an Armageddon scenario. Disappointing US manufacturing data should be taken in context: the sector accounts for just 15% of GDP; services is the main driver of Western economies.’
3. Too much focus on China
Chinese data and stockmarket performance has been an ‘obsession’ for markets lately but Smith said the focus is ‘misguided’.
‘China’s equity market is notoriously fickle, driven as it is by retail investors,’ he said.
‘Granted, China’s leaders bungled attempts to support the stock market; the now-abandoned ‘circuit-breakers’ arguably making the falls worse, and stoked fear in investors. Still, only a small proportion of households dabble in the stockmarket, which should prevent any market crash from contaminating the real economy.’
He added that there was no correlation between ‘consumption spending and stockmarket returns’ as ‘financial interlinkages are small and companies are not reliant on equity market capital to the same degree as Western counterparts’.
4. China moving to service economy
Chinese stockmarket worries aren’t as important as investors think and they should instead take solace from China’s move from a manufacturing and construction led economy 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,’ said Smith.
‘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.’
He added that January trade data shows the volume of Chinese exports increased in December, helped by the currency devaluation seen 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,’ he said.
5. Don’t stress the falling renminbi
The falling currency in China has spooked investors further but Smith believes this comes down to poor communication by the People’s Bank of China, it’s 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,’ he said.
‘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. 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.’
While Smith is remaining ‘vigilant for signs of deterioration in China’ he is not panicking.
‘We’d escalate the probability of a ‘hard landing’ but only if we see a combination of a marked deterioration in service-sector PMI and other related data; if private sector profit growth starts to recede; if there’s further acceleration of capital outflows, and there is banking sector trouble. Nations and their economies tend to be stable when they are authoritarian, consolidated and closed; or democratic, stable and open,’ he said.
‘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.’