Share markets are over-reacting to China; the long term outlook is generally positive

As the adage goes ‘may you live in interesting times’. In recent months this is unquestionably true as the world grapples with a set of dynamics that are indeed proving to be challenging in the short term.

From a share market perspective, we certainly are living in volatile times.

In the past quarter, there have been a number of geopolitical and economic events that have shaped our current investing environment.

In the shorter term, there have been a number of events that have ‘spooked’ markets and resulted in share markets in particular being driven largely by investor sentiment rather than longer term fundamentals.

MI_Cartoon

This cartoon by KAL appeared on the cover of Economist in 1989.

Recent Market Volatility & China

Following various interventions in 2015 by Chinese authorities to manage the volatility of the Shanghai stock market and the yuan exchange rate, they intervened again on 4 January 2016 in an effort to halt declines in the Shanghai stock market.

The catalyst for this decline was weaker than expected Chinese manufacturing activity.

Across the New Year period, a very quiet time in financial markets, the impact of weaker than expected news was magnified to the downside.

In response to this news, the Shanghai market declined quickly and Chinese authorities implemented circuit breakers (i.e. closing the market to halt the decline).

Market participants, realising that circuit breakers would likely be triggered, rushed their sell orders into the market and thus the actions of authorities actually added to short term volatility rather than mitigating it.

This started a contagion effect to other global share markets, ours included. As we know, markets are prone to overreaction. This is highlighted in the table below.

Table 1 REV Jan 16

Chinese economy still growing at a respectable 6% or more

The situation in China is complex in that the Chinese authorities are trying to manage the liberalisation of the world’s second largest economy in a more ‘hands on’ way than is typical in a western-style free market economy.

This program of managed liberalisation is a driver of volatility in itself, as global market participants on one hand seek to anticipate the actions of Chinese authorities and on the other react to them once they occur. The heavy focus on the actions of Chinese authorities is likely to cause further bouts of volatility like the one currently being experienced.

Despite the short-termism of markets, the Chinese economy continues to grow at a rate above 6.0% p.a. (latest official Chinese report is 6.9%p.a.).

While manufacturing activity is slowing, the level of activity in the Chinese services sector is growing. This is an encouraging sign for Chinese authorities as they attempt to navigate a transition from an export-led economy to one more driven by domestic consumption.

However, this positive sign is not something financial markets seem to be focusing on. This is somewhat surprising given that services now make up more than 50% of the Chinese economy and a transition to more stable and balanced growth is exactly what China needs.

Undoubtedly, the Chinese transition is a major undertaking and will not occur without a few missteps along the way.

Fundamentally we see it as a positive for the global economy longer term.

The US economy on its way back

At its meeting on 16 December, the US Federal Reserve (Fed) finally increased official interest rates in the US. This much anticipated action sent the strongest message yet that the US economy is finding its feet again. Subsequently, data released later in December showed US non-farm payrolls rose by 292,000, providing further validation of the Fed’s view.

From an investment perspective, this action by the Fed draws a line under interest rates, in that US rates are unlikely to go materially lower and the recovery of the US economy, while still relatively benign, is nonetheless underway.

While these are positive signs from the US economy, the challenge for the US and other developed world economies is to see a sustained increase in consumer demand.

Ongoing turmoil in the Middle East a cause of investor unease

Religious tensions in the Middle East along with the rise of Islamic State continue to be a source of social, political and economic instability. Such tensions would have typically caused a spike in the price of oil. However, with ‘peak oil’ a distant memory, an abundance of global supply, and the significant development of alternative fuel sources, events in the Middle East no longer seem able to have the influence over the oil price they once did.

Commodity prices still waning

The changes in the dynamics of the oil market have interestingly also played out for other major commodities with prices for most key metals experiencing similar declines (see Chart 1).

Cahrt 1 REV Jan 16

The widespread price declines are not overly surprising. The rapid growth in the Chinese economy through the late 1990s and the early 2000s resulted in resource commodity demand outstripping supply. Commodity producers responded by significantly expanding production capacity to meet what at the time was apparent insatiable demand from China.

However, after the global financial crisis, China’s growth rate began to slow and consequently so did their growth rate in demand for resources and commodities.

The commodity producers didn’t react swiftly enough to the reduced demand growth and as a result we have an oversupply of resource commodities and hence, the much lower prices we have today.

Ongoing weakness in commodity prices is expected to result in attrition and consolidation among commodity producers as those with low cost of production and adequate scale being best placed to endure a period of lower prices.

It is worth noting that while iron ore prices are down by 67% in the last two years, China’s imports of iron ore reached an alltime high of 952.7 million tonnes in 2015, up 2.2% from 2014. So it is encouraging that demand remains strong.

Supply is expected to remain strong but as the supply side rationalises to re-stablish a better balance with demand, prices are expected to stabilise with the prospect of some improvement over the medium to long term.

This will be beneficial for producers and a positive contributor to Australian export growth.

Table 2 REV Jan 16

Australian economy has positive signs

The Australian economy is growing at 2.5% annualised and has been buoyed by the recent housing construction boom.

As the boom wanes, the challenge will be for other sectors of the Australian economy to take up the mantle.

The biggest fillip would be stronger than expected growth in China leading to a recovery in commodity prices. However this is not our expectation in the near term.

Barring that, the lower level of the Australian dollar (a decline against the $US of 36% from the high of 2011, see Chart 2 below) will be supportive of our export sector; namely tourism/ hospitality, education and agriculture.

Other positive economic signs include the unemployment rate remaining stable at 5.8%, continuing wage growth of around 2.3% p.a., interest rates remain at historical lows and there is the prospect of further interest rate reductions should economic conditions require it.

While our expectation is that growth will remain positive for the Australian economy through the first half of 2016, without a stronger growth catalyst the Australian economy could be in for more challenging times later in the year.

In the medium to long term, lower oil prices and the lower level of interest rates should prove supportive of business investment and both consumer and business confidence. This gives a solid base for the Australian economy to transition toward other sectors with more sustainable growth.

by Jeff Mitchell, Head of Investment Research, Australian Unity Personal Financial Services

Disclaimer: This article is not legal advice and should not be relied on as such. Any advice in this document is general advice only and does not take into account the objectives, financial situation or needs of any particular person. You should obtain financial advice relevant to your circumstances before making investment decisions. Where a particular financial product is mentioned you should consider the Product Disclosure Statement before making any decisions in relation to the product. Whilst every care has been taken in the preparation of this information, Australian Unity Personal Financial Services Ltd does not guarantee the accuracy or completeness of the information. Australian Unity Personal Financial Services Ltd does not guarantee any particular outcome or future performance. Australian Unity Personal Financial Services Ltd is a registered tax (financial) adviser. Any views expressed are those of the author and do not represent the views of Australian Unity Personal Financial Services Ltd. If you intend to rely on any tax advice in this document you should seek advice from a tax professional. Australian Unity Personal Financial Services Ltd ABN 26 098 725 145, AFSL & Australian Credit Licence No. 234459, 114 Albert Road, South Melbourne, VIC 3205. This document produced in January 2016. © Copyright 2016