2016 is only one week old and has already made headlines for having been one of the worst starts to a New Year in global capital markets. Some of the trends of 2015 continue with falling commodity prices, particularly oil and concerns over the state of the Chinese economy and the Chinese government’s ability to manage its currency adjustment.
The falls of 10% in the Chinese stock market last week, caught may investors and analysts by surprise. The months running up to Christmas where showing signs of a strengthening world economy with some improving economic data, 2016 looked like a year able to provide better returns than the highly volatile 2015. For example, the Markit Purchase Managers Index (PMI) across the world was showing an increase in confidence.
However just as we saw last summer, China’s volatile stock market has spooked investors around the world. A key question is whether investors have over-reacted to reasons for the falls.
The first week of trading was affected by lower than expected Chinese Manufacturing PMI data for December. The index fell from its pre-Christmas levels indicating a fall in confidence. Another factor effecting stock market sentiment was the end to a ban on selling shares by major Chinese shareholders. This was not an issue about the state of the economy, but shareholders taking profit from the autumn rally when they had the chance to.
Perhaps the most concerning event was the Chines central bank allowing the Renminbi to devalue against the US$. The Peoples Bank of China (PBC) reduced its daily rate for the Renminbi by 0.5% which is the largest downward move since last Augusts 2% devaluation. That devaluation resulted in major stock market losses. The PCB later hinted that it could allow the Renminbi/US$ exchange rate to be determined by the market.
The implication of China devaluing its currency in response to other central banks that have devalued their own currencies through rate reductions or quantitative easing (QE) is one of global deflation.
In December, the Chinese authorities spent US$ 120bn of their foreign currency reserves. This is massive state intervention to defend the exchange rate. The intervention sought to protect the Renminbi against the ever strengthening US$ and stem capital outflows from China. Chinese foreign currency reserves have fallen from US$ 4tn to US$ 3.33tn. They are using up their reserves at an alarming rate and are getting closer to the US$ 2.6tn deemed by the International Monetary Fund (IMF) to be the prudent level given China’s US $1.2tn domestic liabilities and the size of its economy. At current spending rates China has six months before China’s once mighty arsenal of capital looks a little inadequate. The authorities are caught between monetary tightening which is the result of selling reserves and maintain the strength of its currency.
Global markets are acutely sensitive to any signs that China may abandon its defence of the Renminbi, while any currency war would damage global growth.
The Chinese stock market is largely uncorrelated to the real China economy. When the stock market doubled in value last year only then to give up those gains, neither really represented the “real” Chinese economy. Chinese GDP growth is largely unchanged. We know the economy is inevitable slowing but it is not coming to a haul. The old manufacturing heartlands are in decline but the service sector new economies remain strong. China is about both of these sectors. The transition from export to investment led consumption is progressing but clearly not smoothly. This progress can offer excellent investment opportunities for stock pickers but these opportunities are currently being undermined by a lack of confidence in the overall economy and competence of the Chinese authorities.
Markets have taken the December rise in US interest rates very well and the rise has in turn strengthen the US$. Any currency devaluation will increase the relative value of US$ and as commodities are priced in US$ will impact on commodity prices.
There is a general expectation that the Federal Reserve Open Markets Committee will progressively increase US interest rates by small increments throughout 2016, starting perhaps in March or June. However, any slowing of the global recovery may have the effect of delaying such increases.
One aspect of the US economy that is proving resilient is the level of new jobs being created. The US added 292,000 new jobs in December, which was significantly higher than economists had predicted. In 2015, 2.65 million new jobs were created and is evidence of the growing strength of the US recovery. The Fed is expecting new job growth to continue throughout 2016 with Janet Yellen suggesting that the US may create full employment by 2017. These job growth figures are a vindication to the Federal Reserve’s much debated decision to raise interest rates for the first time in a decade.
Oil has hit its lowest price per barrel at US$32 since April 2002. The falls are due to a lack of global growth resulting in reduced demand and a massive oversupply in the market.
The renewed tensions between Iran and Saudi Arabia would have in the past put pressure on oil prices. This time there appears to be an expectation that rather than hostilities in the Middle East, the more likely outcome is the intensification of the oil price war further undermining OPEC’s price cartel.
Saudi Arabia currency, the Riyal, came under pressure last week as the price of oil fell to a US$32pb. Any devaluation of the Riyal could spark a wave of deflation and protectionist policies within the global economy. Saudi Arabia is the world largest producer of crude oil and has a war chest of foreign currency reserves to use to defend its currency. However, the falling price of oil has seen these reserves fall from US$732 last year, down to US$623 indicating the cost of maintaining high oil production and a low oil price.
Investment Bank Goldman Sachs has warned that despite Beijing’s efforts to prop up their currency, the PBC may be forced to abandon its support and allow devaluation. Just as the US and Europe sought to recover from the financial crisis through currency devaluation, reduced interest rates and quantitative easing, the fear is now that even the mighty China with its massive foreign currency reserves may need to do the same. The implications are significant to world markets as currency devaluation will create deflation but reduced interest rates and QE will support real asset values.