With the recent turbulence in the stock markets below is a view from Quilter Cheviot which sums up last week’s events in China and also addresses why we are still positive about equities
A bear in a China shop?
Global stock markets fell sharply last week on concerns about the robustness of the Chinese economy. This, combined with the anticipation that the US central bank may raise interest rates as soon as next month was enough to send share prices tumbling. The UK FTSE 100 fell by 363 points over the course of five days, a fall of around 5.5%. US and European markets dropped by similar amounts. The downward trend has carried on into this week.
Should investors be worried?
The Chinese economy has been slowing for some time. This is in part a deliberate policy by the authorities who wish to see the country shift from a reliance on exports to a greater emphasis on domestic consumption. This transition also coincides with a reduction in capital investment and infrastructure spending which China had embarked upon in the aftermath of the global financial crisis in order to shore up the economy. Thus, GDP growth of over 10% per annum has now slowed to around 7%. The reason for the market jitters, however, is the fear that actual growth is somewhat below that figure. Recent data showed that exports fell by 8% in the year to June. This was followed two weeks ago by a “mini-devaluation” of the Chinese currency, the yuan. Coincidence? The Chinese would say yes, that the change in the currency regime from a fixed peg against the dollar to a more flexible, market influenced rate was aimed at improving the chances of the yuan being accepted as a reserve currency by the IMF later this year. Indeed the currency adjustment was around 3%, hardly a major devaluation. Sceptics would say no, the economy is clearly floundering, a view supported by numbers last week which showed China’s manufacturing sector shrinking at its fastest rate since 2009. And look at commodity prices they would say. Oil back below $50 per barrel and metals prices at the lowest for six years.
So who is right?
Firstly, the link between falling commodity prices and slower Chinese growth is not as straightforward as one might think. True, China is the largest importer of oil and minerals in the world, but even if economic growth this year is only 6% (less than official forecasts), the absolute level of imported materials is around the same as it was five years ago when commodity prices were booming. This is simply because the Chinese economy is now much larger in size compared to five or six years ago. Weak commodity prices are largely a function of excess supply rather than a collapse in demand. With oil, we have seen the huge ramping up of shale production in the US. This combined with higher OPEC output and the likelihood of Iranian oil coming back to the market has pushed prices back below $50 per barrel. In the case of metals, new production which was planned some years ago is only now coming to market, sending prices lower. So, while commodity producing countries such as Brazil are indeed suffering because of low prices, many other parts of the world are better off, seeing lower input costs in manufacturing. Lower oil prices are also resulting in lower diesel and petrol prices, boosting disposable incomes for consumers.
What about interest rates?
It is widely believed that the US will be the first major economy to raise interest rates with much commentary centred around September as the likely starting point. However, the recent further fall in the oil price suggests that inflation levels will remain subdued for the foreseeable future. This seems sufficient for the Fed to stay its hand for now. Nevertheless even if rates were to rise next month, it is likely to be a token increase, with subsequent movements very slight indeed. In the UK, inflation is also conspicuous by its absence and any move seems unlikely until well into next year.
Is the global economy in trouble?
Even with a lower Chinese contribution to global activity, world growth is likely to be above 3% this year. The US economy, still the world’s largest, is in good shape, with jobs being created, a housing market that is recovering and low inflation. Growth should be around 2.5% this year. The strengthening dollar is a headwind for some companies, but the economy is well balanced and lower oil prices translate to more consumer spending power. The UK is also in good shape and should show a similar growth rate to the US this year. Again, low inflation is allowing real wages to rise, boosting consumer spending. The prospect of higher interest rates seems some way off into the future. The Eurozone is financially more stable now that Greece has secured its bailout. Quantitative easing (QE) and the lower euro should allow growth to improve from a very low base. Outside of China, however, the prospects for Asia and emerging markets is mixed. Japan is seeing modest improvement on the back of QE after years of contributing nothing to global growth. In the developing world, some countries are being hurt by lower commodity prices, but others who mainly import raw materials are benefitting from lower costs.
And the outlook for markets?
Share prices have suffered a sharp correction in the last few weeks, albeit after many stock markets reached all-time highs in the spring. Valuations are around the average for the last twenty years, so the current weakness offers a good entry point. Moreover, dividend yields remain well above government bond yields, underlining the income attractions of equities. Low commodity prices are likely to keep the lid on inflationary pressures, removing the need to raise interest rates. This suggests that bond yields are likely to remain low for some time. Therefore, while stock markets may remain volatile over the coming months, investors shouldn’t be afraid of taking advantage of the recent dip in prices to add to positions where they can.