CHINESE CHECKERS: HOW THE GLOBAL GAME HAS CHANGED
After a turbulent few weeks in markets, Stephane Monier, CIO of Lombard Odier (Europe) reflects on the recent upheaval and how it has affected our views. Much, he feels, comes down to one key question: how worried should we be about China?
We can pinpoint four Chinese “triggers” for the recent market rout:
- 1. The bursting of stock market bubbles in Shanghai and Shenzhen
- 2. The shock 11 August devaluation of the domestic currency, the renminbi (RMB)
- 3. Mounting evidence of a slowdown in economic demand
- 4. The reactions of the Chinese authorities
Meanwhile, China’s troubles have sharpened our focus on four further points of note:
- Debt accretion, both in China and globally
- China’s reduced demand for commodities, amid a structural oversupply
- A lack of liquidity in credit markets
- Scant room for manoeuvre in developed market monetary policy if China’s troubles spread
So what should we make of the four triggers and resulting observations?
We believe sharp falls in Chinese stock markets, while painful for local investors, were more a necessary correction than a symptom of wider economic malaise. Onshore equity markets in Shanghai and Shenzhen have fallen by 36% and 40% respectively since the start of June*. However, this comes after a multi-year run-up in prices that was in part engineered by the Chinese government. The Shanghai index still trades at a more than 50% price/earnings premium to the Hang Seng index, and Chinese equity markets are less reflective of economic fundamentals than in more developed countries. Their free-float is around a lowly third of gross domestic product (GDP), and only 6% of Chinese households own equities, according to the Shanghai-based China Market Research Group, with some two-thirds of stocks in government hands.
We don’t expect China to embark on a full-scale competitive devaluation. China’s unexpected RMB devaluation on 11 August 2015 shocked the market, and there were fears the country might be seeking a competitive devaluation to boost exports. This seems unlikely in our view: such a move would be counter-productive for China’s shift to a consumption-based economy, and could trigger damaging capital outflows. Greater freedom for its currency should give China greater flexibility in conducting its monetary policy; could help reintroduce a little domestic inflation, which could boost consumer-facing companies; and should also help the authorities’ aim to have the RMB included in the International Monetary Fund’s basket of Special Drawing Rights currencies. While we see room for further downward pressure on the RMB, we believe this is likely to be implemented gradually and in a controlled fashion.
China’s economy is certainly slowing, but little has changed in terms of economic fundamentals. The prelude to China’s “Black Monday” on 24 August 2015 was the publication of Caixin’s August Manufacturing Purchasing Managers Index** (PMI), which registered its biggest fall since 2009. But investors have long suspected China is unlikely to make its official 7% growth target this year. Too great an investor focus on manufacturing is also misleading: in recent years China has been making a painful readjustment from state infrastructure spending, heavy industry and cheap exports towards a more consumer-led growth model. This seismic shift is already well underway: services overtook manufacturing and construction in importance as an economic driver back in 2013. Recent manufacturing data weakness seems insufficient to signal an imminent collapse in domestic demand: retail sales continue to climb, Apple recently noted strong growth in China in July and August, and Caixin’s Services PMI reached an 11-month high in July. We believe recent cuts to interest rates and banks’ reserve requirements, together with an expected restocking after three quarters of inventory depletion, should combine to boost growth in the fourth quarter.
The perceived inconsistency of Chinese authorities’ reactions to market events does pose some concern. After the shock RMB devaluation, Chinese authorities also appeared to waver on their reaction to falling stock markets: intervening in June, but becoming more laissez-faire by August. Back in 2008, a massive domestic stimulus package helped buoy the Chinese economy when most developed economies were spiralling into recession, but now the authorities seem torn between intervention and more free-market policies. Could they be losing their grip on the economy as it grows and changes? Certainly, we share concerns over the future efficacy of domestic economic policy. But we also note that significant firepower remains on both fiscal and monetary fronts to support the economy, and we believe the Chinese authorities will continue to want to use it.
Debt accretion is a longer-term worry. China’s debt build-up in recent years has been significant, even in an era where total global debt as a percentage of GDP is estimated to have risen from 246% in 2000, to 286% in 2014***. Outstanding loans for Chinese companies and households stood at a record 207% of gross domestic product at the end of June 2015, up from 125% in the same period in 2008, according to data compiled by Bloomberg. Much of the accumulated debt is concentrated in companies in China and other emerging markets, as well as in high yielding companies in the energy sector, where we note that rising default levels could present problems in future.
China’s lower expected demand for oil exacerbates a structural oversupply. Recent equity market falls have been accompanied by further commodity price weakness, as the world reassesses Chinese demand. China consumes 54% of the world’s aluminium, 22% of its corn and 12% of its oil, according to analysis from the Wall Street Journal. But even as demand dips, and crude oil prices hover around $40-$50 a barrel, Saudi Arabia and Iraq have ramped up oil supply this year. Data from the US Energy Information Administration on 26 August 2015 showed a record high in crude and petroleum product inventories. More production expected to come online from Iran in 2016 could exacerbate the oversupply.
China’s stumbles have revealed a lack of liquidity in credit markets globally. Bond dealers’ credit inventories have fallen sharply since the 2007-2009 financial crisis, as a result of risk deleveraging imposed by regulators on banks, constraining their market-making capacity and adversely affecting credit market liquidity. In recent weeks, volumes of credit transactions have collapsed and bid-ask spreads have increased, particularly in the high yield segments, leaving the market vulnerable to a reversal in flows’ direction.
Meanwhile, central banks in Europe and Japan are already engaged in quantitative easing, and benchmark US, European and Japanese interest rates stand at or below 0.25%. In this scenario, we note that developed markets would have little monetary room for manoeuvre if China’s slowdown proves more serious than expected.
That said, we believe that recent market sell-offs appear to be pricing in global recessionary risks. Even after the events of the last few weeks, we believe this seems at odds with the current soft but steady economic environment across much of the developed world.
* Data throughout this article correct as of 28/8/15. Sources unless stated otherwise are Bloomberg, or Lombard Odier analysis
** A Purchasing Managers Index is an indicator of the economic health of the private sector. The index is derived from monthly surveys of purchasing managers at private companies, which means it can be more forward-looking than other indicators, including retail sales or gross domestic product growth figures.
*** Source: McKinsey
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