Chinese market woes trigger global sell-off in equities

Global equity markets have started 2016 on a bad note with broad indices down 4 to 8 percent.

The local Chinese stock market slumped 15 percent so far this year, triggering two market closures within four days there.

What are the factors behind the current market rout?
At the heart of the issues are China’s economic woes. There is little doubt that China is facing severe downward economic pressure as the rebalancing from heavy industry and exports to consumer-led growth is proving hugely challenging. The massive interventions during the summer of 2015 aimed at stabilising local equity prices have failed to restore confidence, and are raising credibility issues for the Chinese authorities. In addition, China has de facto abandoned its soft peg of its currency to the US dollar by broadening the reference to a currency basket, fueling uncertainty. Lower Chinese demand has triggered a downward spiral in commodity prices that puts producers and emerging markets under increased pressure, resulting in a deterioration of credit quality and devaluation of emerging-market local currencies. Slower Chinese growth and lower commodity prices mean lower global growth, lower inflation, lower global corporate earnings but a bonanza for the western consumer.

What to expect?
Chinese authorities will most likely intervene again to prop up local stocks. While the long-term success of such actions is doubtful (the price-finding mechanism is thus merely deferred), it might work in the short term. China has enough firepower and is clearly ready to act. The country has still room to ease monetary policy further and implement fiscal stimulus. In such a context, commodity prices remain under pressure, as do emerging-market assets in a broad sense. At the same time, earnings prospects of key equity sectors such as energy, mining, industrials, automotive or luxury goods appear challenged. Even though US manufacturing activity is weak, the domestic strength and employment gains still speak for a gradual tightening of the U.S. Federal Reserve’s Fed monetary policy. It is fair to say, though, that the Fed may also wait longer than expected before hiking rates further in light of the current events. Lower growth and lower inflation will certainly encourage the European Central Bank (ECB) and the Bank of Japan (BoJ) to pursue their massive liquidity programmes.

How are we positioned?
We have used the December 2015 equity-market weakness to raise our equity exposure to a moderate overweight (from neutral) by adding to our positions in developed-market stocks. Our portfolios are thus not immune to the recent sell-off. Markets are oversold and investor sentiment is negative, which is why we stick to our exposure for now. That being said, we are aware of the risk to global growth and global profits and are ready to reconsider our position if need be. We still run a substantial underweight stance towards emerging markets (both in equity and fixed income) and have little exposure to the equity sectors and countries directly affected by the issues mentioned above. We also run an underweight toward commodities, even though current prices start to look quite attractive given the cost curve of most producers. With crude oil trading barely above 30 US dollars per barrel, many oil companies no longer cover their costs. However, the ongoing cutbacks in capital spending and the ensuing lower production will bring the market back into balance over time. As a matter of fact, we expect a recovery in the oil price towards 50 US dollars in the second half of 2016. We have recently re-established an exposure to gold as we consider its near-term risk/reward attractive.

Is it the end of the long bull market for equities?
While the issues are serious – particularly the deterioration of credit quality across emerging market and commodity-related sectors – a bull market usually ends with a recession, which is in turn triggered by a tightening of monetary policy. In the current context, a recession scenario in developed markets appears highly unlikely given that the large central banks’ monetary policy remains hugely accommodative. In addition, the recent 25-basis-point Fed hike is not enough to make US monetary policy tight, to say the least. However, the situation in emerging markets remains problematic, with some key countries such as Brazil or Russia in deep recession. The divergence between a strong domestic picture in the US, UK and the euro zone on the one hand and weak emerging markets and global trade on the other hand is a source of volatility for financial markets.

What to do?
With investor sentiment deeply negative and risk aversion elevated, it is probably a bit late to sell. Our inclination is rather to look at buying opportunities in selected areas, without losing sight of overall portfolio risk and assessing the probability of events or catalysts which could lead to a more somber scenario.

Christophe Bernard – Chief Strategist – Vontobel