When even Beijing’s official state news agency starts talking about “Black Monday”, you know something serious is happening. The Shanghai Composite Index suffered its worst one-day slide since 2007 last Monday, losing 8.5% and wiping out all its 2015 gains. The shockwaves spread around the world, with many markets posting daily falls not seen since the global crisis.
The pan-European FTSE 300 lost 7% and the FTSE 100 5.5%. UK stocks have lost around 15% from their recent high. The MSCI Emerging Markets Index tumbled to a six-year low. Global stocks have lost $5trn since China devalued its currency a fortnight ago. Emerging-market currencies have tanked. Commodities continued to hit multi-year lows.
On Tuesday, Chinese stocks fell another 7.6%. European markets bounced when the People’s Bank of China rode to the rescue. After the Shanghai market closed, it cheered investors by cutting interest rates by a further 0.25% and lowering the reserve requirement ratio (RRR) – the amount of cash banks must keep on reserve rather than lend out – by 0.5% to 18% for large banks. But US markets continued to slide, and by Wednesday investors were fretting again.
The China syndrome
Few overseas investors own mainland Chinese equities, says Peter Thal Larsen on Breakingviews.com. As a result, China’s equity boom and subsequent bust “barely registered on global markets for most of this year”. But “that has now changed”. Global investors have lost confidence in Beijing’s ability “to micro-manage the financial sector – and steer a slowing economy”.
China’s official data are notoriously unreliable, so there is widespread uncertainty over the extent of the slowdown in China, a key driver of global growth in recent years. Beijing’s devaluation of the yuan earlier this month, however mild, suggested that they were very worried about the outlook – a fear apparently confirmed by last week’s news that the manufacturing sector is shrinking at its fastest pace since 2009.
The shift from an export and investment-heavy economy to a consumer-orientated one is clearly “proving exceptionally difficult”, says Jeremy Warner in The Sunday Telegraph. To make matters worse, the government “badly mishandled” the decision to devalue and the recent stockmarket crash. Its futile efforts to prop up the market dented confidence in the regime and reinforced capital flight, “thereby undermining already fragile credit conditions” and hampering the economy further.
A deflationary tide?
China used 11% of the world’s oil last year and hoovered up 57% of its copper. With growth slowing, demand for commodities has ebbed too, undermining momentum in commodities exporters such as Brazil and Russia. Meanwhile, most other Asian countries have close trade links with the Middle Kingdom. Korea, Hong Kong and Taiwan, for instance, earn 11%, 15% and 25% respectively of their GDP by exporting to China.
In addition, the prospect of higher US interest rates (until this week, the Federal Reserve had been expected to raise rates next month) has been drawing global cash away from traditionally risky assets such as emerging markets. On top of that, some emerging countries, notably Malaysia, Ukraine and Turkey, have high US dollar debts, so the rise in the value of the dollar and the slide in the value of their own currencies have squeezed them further. Add it all up and you can see why investors fear “a deflationary tide” from slowing emerging markets and their falling currencies, said Richard Barley in The Wall Street Journal.
Deflation would spread to the industrialised world via lower import prices as emerging economies race to devalue their currencies – a “currency war”. With inflation already barely positive in much of the developed world, a deflationary Japan-style slump – where falling prices would increase the “real” value of our still-huge debts – is a distinct possibility.
With many companies in major developed-world markets making most of their sales overseas, with a fast-rising share going to developing countries, it’s no wonder they’re suffering. Deutsche Bank reckons that China accounts for 15% of profits at large German companies, for example.
Is the panic overdone?
Nonetheless, investors “are hardly known for taking measured views when markets get topsy-turvy”, says The Economist. And they may be getting carried away. For starters, while the data show that China is slowing, it’s not collapsing. Amid all the drama, few appear to have noticed that the Chinese services sector, which eclipsed manufacturing two years ago as the biggest part of China’s economy, is looking healthy, with a survey tracking activity in the sector reaching an 11-month high in July. “China is not just about heavy industry.”
Meanwhile, the property market is coming back to life. “The property crash is already a memory,” says Ambrose Evans-Pritchard in The Daily Telegraph. House prices have risen for three months and sales were up 18.9% year-on-year in July. “This matters more than anything happening on the Shanghai stock market.” Credit-ratings agency Moody’s calculates that the housing market and related industries comprise 25% of Chinese GDP. Lower interest rates and an easing of restrictions on speculation have caused the turnaround.
In short, “the economy is… coming back to life after hitting a brick wall over the winter”, continues Evans-Pritchard. Credit growth has hit a 31-month high and the money supply is expanding, implying higher growth later this year. Longer term, this renewed stimulus bodes ill, as it merely re-inflates the credit bubble of recent years. But for now, China is not in crisis, and the government has plenty more scope to cut rates and the RRR.
The developed world isn’t exactly in crisis either, as Patrick Hosking notes in The Times. America and Europe, which jointly account for 40% of global GDP compared to China’s 15%, have strengthened in recent months. And the slump in commodity prices amid China’s slowdown is “a blessing, not a curse”. Firms and households will have more money to spend and invest.
Can the central banks save us?
Even so, rattled investors – spoiled by years of coddling by central banks – are calling for more stimulus. China has already acted. Many now expect the Federal Reserve to delay its first interest-rate hike in almost a decade. By keeping monetary policy loose, central banks should ensure plenty of liquidity flows into asset markets. They could even print more money if economies really do take a turn for the worse.
Indeed, with high-profile names already calling for “QE4” – yet another bout of quantitative easing – from the Fed, the real risk may be that central bankers overreact to the deflation threat and step up QE “to such a pace that you will hear the roar of the printing presses from Mars”, as Albert Edwards of Société Générale put it.
What do China’s woes mean for your money?
We’ve written in recent months that we think China is set for a longer-term bull market as it shifts its economic focus towards a more consumer-led economy. That process was never going to be smooth, and we haven’t changed our view.
We suspect a decent buying opportunity is coming up later in the year. That said, we’d certainly recommend that you continue to own gold in your portfolio as insurance. Its fortunes have improved in recent weeks amid uncertainty over China’s revaluation of the yuan, and if central banks indulge in more QE, gold is one of the few assets that should hold up in a full-blown currency war.
In terms of opportunities, the mining sector has been hit very hard and, as yet, there’s no sign of an upturn in the commodity markets. That said, mining giant BHP Billiton (LSE: BLT) is now trading on a prospective dividend yield of more than 8%. That suggests the market is sceptical of its ability to keep paying out, but the company has reaffirmed its commitment to doing so this week.
That doesn’t meant that it will, of course – but if fear over China does bottom out, now could be a good time to buy. Meanwhile, surprising as it may seem, markets in eastern Europe have been among the emerging markets that have weathered the Chinese storm best.
As one US fund manager tells Barron’s, the region is “a bit of a safe harbour”. That’s because, unlike the most popular emerging markets, they have little reliance on China and are also net beneficiaries of lower commodity prices, being consumers rather than producers. MoneyWeek’s regular contributor, Jonathan Compton, flags up his favourite plays on the region.