James Bevan: Equities, troughs and optimism
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James Bevan
An equity bear market only looks likely if there’s a sustained downturn in economic activity levels, but the 6.0% drop in the S&P500 last week was the worst first-week-of-the-year drop on record – whilst the second worst first-five-trading-day period of the new year occurred in 2008, which ended down 38.5% as recession unfolded.
Looking at the ten worst first-five-day records for the S&P500, that index was down 4.0% on average, with four up years averaging a gain of 11.2%, and six down years averaging -14.1%.
To sum up market concerns, on 1th January in the FT, Larry Summers wrote:
Traditionally, international developments have had only a limited effect on the US and European economies because they could be offset by monetary policy actions.
Thus, the US economy grew robustly through the Asian financial crisis as the Fed brought down interest rates. With rates essentially at zero in the industrial countries, however, this option is no longer available, and foreign economic problems are likely to have much more of a direct effect on economic performance.
Because of China’s scale, its potential volatility and the limited room for conventional monetary manoeuvres, the global risk to domestic economic performance in the US, Europe and many emerging markets is as great as at any time I can remember. Policymakers should hope for the best and plan for the worst.
There’s a general concern amongst commentators that the old growth engines in China appear to have run out of steam and the Chinese consumer won’t pick up the slack to deliver the global growth that we’ve become accustomed to.
As part of the concern, there’s a rising worry that China’s official retail sales figures are inflated with households tending to save and funds used to finance too much infrastructure and production capacity with not enough spent on expanding the services economy. Meanwhile, income and wealth inequality has stymied the growth of a true middle class and the government’s anti-corruption campaign has depressed spending by high-income consumers.
Rout, plunge and currency
Last week’s global stock market rout was widely attributed to the plunge in Chinese stock prices following the release of another weak M-PMI (purchasing managers index) on Monday. The Shanghai-Shenzhen 300 index fell 9.9% last week and is down 13.8% since the end of last year.
But it doesn’t look as if the M-PMI has been the real problem. It actually edged up to 49.7 from 49.6 during November, and it has been just under 50.0 for the past four months in a row, and the output component of the M-PMI was 52.2, close to its average reading over the past five years. The actual problem seems to be that mounting capital outflows are depressing the foreign exchange value of the yuan.
China’s weaker currency is a threat to the competitiveness of exporters in other emerging economies, who are already suffering from weaker sales to China. The currencies of many of those emerging economies have already depreciated significantly over the past three years. Another round of currency devaluation might trigger a wave of defaults by companies that borrowed in stronger currencies. This has upset stock, commodity, and currency markets so far this year.
Digging into the details, the weakness in China’s M-PMI in recent months has been long heralded by the deflationary trend in its PPI, which was down 5.9%yoy (year on year) during December, the 46th consecutive monthly decline. The PPI in manufacturing was down 5.4% last year, while the PPI for raw materials was down 10.3%. Then on 26th December it was announced that profits for China’s industrial companies had fallen 1.4% yoy in November, this being the sixth consecutive month of decline. Industrial profits of large enterprises, defined as those with annual revenue of over $3.1m from their main operations, fell 1.9% in the first 11 months of the year compared with the same period a year earlier.
Meanwhile there have been mixed signals on China’s services economy. On 31st December, it was disclosed that the official NM-PMI rose to 54.4 in December, the highest since August 2014. Then on 5th January, Caixin/Markit reported that their unofficial NM-PMI for December fell to 50.2 – the weakest level since July 2014 – suggesting that the transition from manufacturing to services isn’t going well. That’s totally at odds with the official stats but there’s increasing unease on the official numbers.
These issues aren’t unimportant but arguably the big issue for global financial markets has been the weakness in the yuan, which is down 1.2% ytd and 8.1% from its peak of 6.04 per US dollar on 14th January 2014. There has been a relatively good inverse correlation between the yuan and the Emerging Markets MSCI stock price index (in local currencies), and the depreciation of the yuan could weigh heavily on exporters in other emerging markets and impair their ability to pay their foreign-currency debts, as noted above.
Grounds for optimism
Then again, most EM currencies have been weak for a while now with the Emerging Markets MSCI currency index down 15.5% from the peak in 2014 and thus far, there’s been no EM crisis triggering global financial upset, and the weaker yuan does boost the purchasing power of consumers in developed markets if they were minded to spend.
When all is said and done, China clearly does have a capital outflow problem, as evidenced by the $665bn drop in its non-gold international reserves since the peaked at $4.01tn in June 2014.
Over the same period, the yuan fell 5.7%, implying that it would have fallen more but for FX intervention by the government and subtracting the 12 month change in China’s international reserves from its 12 month merchandise trade surplus implies capital outflows of $1tn over the past year through November. The actual outflow might be half as much given that China’s reserves data are denominated in dollars but include major currencies like the euro and the yen that have depreciated appreciably.
So, there are plenty of uncertainties and things that we don’t and can’t know. For now markets are assuming the worst and bad sentiment is then causing bad outcomes. But global leading indicators are showing signs of having reached a trough and may be starting to turn upwards, and this provides real hope that year on year equity returns may be close to a trough. Against this backcloth, we see good grounds for optimism.
James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla
*CCLA is a supporter of Room151
