Market Update - August
Market corrections of the nature we are currently experiencing always prompt the question ‘Is there something we are not seeing?’ Is there something lurking in the shadows of the world economy that represents a significant, but to date unrecognised, threat? It would take a brave person to assert that this is absolutely not the case. However, if we reverse engineer what is currently happening in financial markets, we do not arrive at a picture of the world economy that we think tallies with sharp declines, almost across the board, in equity prices.
We are used to volatility in financial asset prices, but it is the suddenness of setbacks, such as that seen over the past couple of weeks, that is so uncomfortable. Albeit, this is against the backdrop of seasonally low volumes, there is clearly something that is causing anxiety. The two main causes of concern would seem to be the developments in China and the likelihood of a tightening in US monetary policy before the end of the year.
China, as we have observed previously, is a command economy that is failing to respond to commands. The Chinese authorities know what they want to do – they want the economy to become less reliant on exports and generate more of its growth from domestic demand – specifically, household demand. But knowing where you want to go is very different from having an effective way of getting there. Measures designed to stimulate demand have, to date, caused asset price bubbles, first in property and then in the equity market. It is the latter that is now bursting. The reasons for the latest policy announcement, to allow the value of the yuan to reflect more accurately current market forces, have been much debated. However, the timing of the change and the subsequent depreciation in the yuan have caused further concern.
Underlying the slowdown in the Chinese economy is a feature of the world economy that does have major consequences for developing economies. They thrived during the decade prior to the recession when there was rising excess demand in the West. Although these economies are now regaining momentum, recorded growth rates have been, and will likely remain, meaningfully below those seen pre-2008. This provides a very different backdrop for developing economies, whether they be exporters of manufactured goods or commodity producers. As can be seen most obviously in commodity markets, they have far greater output potential than is required. As a result, prices are falling. So far as commodity markets are concerned, it may be some while before conditions change sufficiently to reverse significantly these declines. And while prices remain weak, the environment will be all the more competitive – a situation that will not be helped by China’s decision to allow the yuan to depreciate.
For the West, falling prices of raw materials, energy, foods and manufactured products are not unhelpful. This is not unambiguously the case – we are not only consumers of these products, but also producers. However, the overall impact is favourable - paying less for oil or food means that we have more to spend elsewhere. Countries and companies that export heavily to China are facing a headwind, but they are in the minority. The net impact on the West from falling import prices is that it is likely to grow slightly faster than would otherwise have been the case.
It may be considered ironic that while markets are becoming more anxious about declining growth in countries such as China, they seem to be equally stressed by the implications of gradually improving growth prospects in the West. Central banks have held back so far from responding to improving conditions – most obviously in the US and the UK. However, with labour markets tightening and with rising employment costs suggesting that domestically generated inflation is likely to start rising, the debate has changed to whether the US Fed will start raising interest rates from the crisis levels – and when the Bank of England will follow.
In reality, a gradual (and it will be gradual) tightening in monetary policy ought to be viewed positively – as a sign that we are emerging at last from the shadow of the global recession and financial crisis. However, there are inevitable concerns about the implications of higher interest rates. In part, there is a fear that real economies will prove much more vulnerable to even minutely tighter conditions that would have been the case historically. In addition, there is worry about the impact that rising interest rates will have on the valuations of financial assets.
Our view is that modest rate increases in the US and UK will not have a major impact on growth. However, there is the potential for a greater impact on financial markets. In particular, increasing short-term interest rates are likely to put upwards pressure on longer term bond yields. But this would not appear to be the immediate worry in markets, since equity markets in the West have also fallen sharply, while bond markets have rallied.
It’s not unusual for financial markets to display flashes of extreme anxiety. In doing so, they act as shock-absorbers within the global economy. Indeed, the moves we have seen in markets over the last few weeks are completely within the bounds of expectations, and historical context, with rational differentiation across markets.
The FTSE 100 Index has experienced a correction of approximately 15% from the April high. This is not out of line with previous market falls of over 10%, and can be considered ‘normal’ in the context of expected volatility. As such, we have experienced similar declines in the equity market every year since 2005. Other developed markets, including those in the US, Europe and Japan, have seen similar declines, while more substantial falls, of over 20%, have occurred in many emerging markets; as mentioned above, the latter have been struggling to re-orientate their economies since the financial crisis and have proven more vulnerable to growth concerns. The correction in the Chinese market has been amongst the most substantial, although this has to be gauged against the extent to which it had previously risen; for instance the Shanghai Shenzhen CSI 300 Index, which has fallen 40% from its June peak, is still up on a 12-month basis.
While equity markets often display more abrupt movements than are seen in other financial asset classes, it is evident that commodities, which are subject to more ‘real’ demand trends, tend to take longer to adjust. The key driver of the decline in commodity prices has been weak global demand in the face of excess supply consequent on the previous production investment cycle. Despite significant cuts in current and planned capital expenditure by major commodity producers, stocks and potential supply are still high and weighing on prices. Oil, in particular, has fallen from a range of $80 - $110 per barrel over the past few years to today’s level of just under $40 for West Texas Oil. Given prevailing supply conditions, it may take time before a sustained price increase is possible.
Sometimes, fears are in line with economic reality. More often than not, fears are exaggerated and/or unwarranted. If this is the case, then the resulting movements in asset prices, and more reasonable valuations, provide investors with opportunities, and we believe that to be the case currently.
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