By Tristan Hanson
With China the world’s second largest economy and the largest trading nation, it is not surprising that events there can have a global impact. But concerns over slowing Chinese growth is nothing new. Similar fears have affected global markets on various occasions in recent years.
What is new though is that investors are increasingly questioning the ability of Chinese policymakers to tackle their problems. But other preoccupations have lingered over markets too. The impact of a move higher in US interest rates has been one. For many investors, so too have global equity valuations, particularly in the US.
Perhaps the biggest fear is the lack of policy options if China tips the world into recession. With interest rates at 0%, the Federal Reserve would prefer to tighten policy but even if it reversed course, would further QE do much good? Europe and Japan are already engaged in QE programmes. In terms of fiscal policy, the US could react but there is zero appetite for fiscal stimulus in Europe. Elsewhere, other emerging economies would have very little room to stimulate meaningfully.
Why we are not so pessimistic
We acknowledge that there is always a high degree of uncertainty when it comes to economic projections. We appreciate there are risks to our view. However, we believe the recent sell-off in developed market equities represents a buying opportunity on a 12-month horizon.
Our reasons are as follows.
1. We recognise that Chinese growth is slowing – something we expect to continue in the years to come. However, we are not as pessimistic as some when it comes to the question of a financial crisis. First, property sector data has been improving and services appears resilient (as far as we can tell). Second, there is so far no evidence of an abrupt tightening in money market conditions. Third, we expect substantial further easing in both monetary and fiscal policy in an effort to stimulate the economy. Fourth, we believe recessions become financial crises when liquidity evaporates during a credit crunch. The fact that the large Chinese banks are state-owned and the financial sector dominated by government policy, a Lehman-style credit crunch is unlikely to occur in China.
2. The domestic services sector in the US – by far the largest part of the economy – appears to be robust. Recent survey readings of supply managers in the US non-manufacturing sector are at their highest levels in 10 years. Labour market strength supports this view. Moreover, European growth is recovering with three quarters of better growth recorded. There is little suggestion in other indicators and surveys we look at that European growth is about to falter.
3. Global equity valuations are not extremely cheap, but neither do they look excessive following the drop in markets, especially against a backdrop of negative real yields on cash and barely positive real yields on DM government bonds. The 12-month forward Price/Earnings ratio for the MSCI World Index is 14.3x (equating to an earnings yield of 7%), while the forward dividend yield is 3.1% (all figures Source: JP Morgan). So long as earnings estimates do not drop significantly (say by more than 10%) over the next year, we think equities are priced to outperform bonds or cash.
4. We expect the Federal Reserve to raise US interest rates soon. However, we expect the pace of US rate hikes to be very gradual. Meanwhile, the ECB and Bank of Japan are engaged in QE and we expect both central banks to increase their overall QE purchases beyond current intentions. Monetary conditions in DM therefore remain very supportive.
We believe the risks remain greater in EM, with the exception of India which we continue to believe is an attractive medium-term proposition. Unlike some EM countries, India is a strong beneficiary of falling commodity prices.
What next for China and its exchange rate?
We expect further significant fiscal and monetary stimulus from the Chinese authorities. The ‘impossible trinity’ – the impossibility of a central bank fixing the exchange rate, allowing free capital flows and controlling domestic monetary conditions – poses a challenge for the People’s Bank of China (PBOC). Capital flows are already negative; increasing domestic liquidity and cutting rates could put further downward pressure on the Chinese renminbi. We therefore expect the PBOC to intervene heavily and it is quite probable that China reverses course on its path towards liberalised capital flows in order to stem pressure on the central bank’s foreign exchange reserves.
Our base case is that the Chinese renminbi weakens further to the order of another 5-10% over the next year. The risk scenario is that it weakens much further given the possible pressure on capital flows. In such a scenario, we would expect EM countries and commodities to remain under pressure.
Volatility is likely to remain higher than it was in 2013/14, but once the dust settles we expect global equities to move higher over the coming 12 months.
Tristan Hanson is head of asset allocation at Ashburton Investments
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