As the summer of 2015 winds down, the peace and calm of global equity markets have been disrupted by significant declines in stock markets around the world. Year to date, most markets are now down in dollar terms, with the S&P showing declines in the 6% range. While not completely unexpected (see our March commentary), these downturns have often been violent and and occasionally precipitous. Concerns have focused on China’s economy, and dramatic falls in domestic Chinese stocks have become commonplace.
In our view, the China issue has been exaggerated and provides a convenient excuse for U.S. equities to come down to values consistent with this stage of the economic cycle. Following six years of almost continuous upward movement, prices for U.S. stocks are generally expensive, with the market priced for perfection. Faced with the prospect of higher interest rates, which will eventually provide an alternative to equities for yield-starved investors, and the likelihood of lower corporate profits, in many ways this adjustment makes sense, though the panicky selling we have seen in recent weeks hardly seems justified.
After a decade of stellar growth, the Chinese economy is returning to earth. This should not come as a complete surprise, as the country strives to manage the transition away from an export-driven, manufacturing economy, to a more service-oriented, consumer economy. While there is little doubt that GDP growth rates are declining, albeit from a high level, the Chinese are in fact making reasonable progress with this rebalancing, with the service sector now accounting for almost fifty (48%) percent of the economy.
Debt levels remain elevated, but they have started coming down and almost all of it is domestic, which means that China’s $3.6 trillion in foreign currency reserves can be used to provide additional economic stimulus. In many ways, this represents a problem, as the natural tendency of the political leadership to veer away from free markets may be exacerbated by having the means to subsidize and stimulate the economy in order to limit domestic political fallout from a slowing economy and declining stock markets.
However, all of this should be seen in context. First, it is important to distinguish between shares listed domestically (A shares) and Chinese companies listed in Hong Kong (H shares). The former have been much more volatile, having risen by 140% in the year ending in May, before plunging by 50% over the last several months. This in many ways is a pattern not untypical of an emerging market filled with inexperienced retail investors, which is exactly what China is. Real estate, which is much important to the Chinese economy, has actually been increasing in value over the last several months. Meanwhile, H shares have been much less volatile, on both the upside and the downside.
Similarly, the decline in the value of the currency has garnered a lot of headlines, but when looked at from a longer-term perspective seems less significant. For instance, the Yuan, or the Renminbi as it is sometimes called, is down a little over 3% YTD (as of Aug 26), but is up almost 30% over the last decade—hardly the type of huge devaluation the press is depicting.
Lastly, it is worth examining China’s trade patterns as markets are focusing on them. For the U.S., exports to China represent less than 1% of GDP. In Europe, the numbers are somewhat higher, with exports to China constituting 6% of sales. Germany is the most exposed, with 10% of the sales of companies listed on German stock market going to China. Even in the Far East, exports to China are not critical for most economies, though countries like Korea and Vietnam will doubtless suffer. Nonetheless, individual companies or sectors of the world economy may be hurt. In particular, commodity exporters and luxury goods manufacturers are feeling the pain of China’s slowdown.
In the U.S., key macro economic indicators remain strong. GDP growth rates are robust and have recently been revised upwards. Unemployment rates continue to decline and durable goods orders are on the uptick. Inflation remains quiescent, while recovery in the housing market continues. On the other hand, company valuations, while more attractive after the recent falls, are still not cheap when measured by the traditional metrics such as price to earning, price to book, or price to sales. With corporate profitability remaining at record highs as a percentage of the economy, growth in earnings are proving harder to come by and will likely to continue to do so.
Two immediate challenges face financial markets: the prospect of Fed action and the potential for contagion spreading from capital markets to the real economy, as was the case in 2008-2009. While all eyes are currently focused on the Fed, here in Jackson Hole we have had the opportunity of interacting with several Governors of the Federal Reserve System, who have made the annual pilgrimage to the Tetons for the Global Central Bank Symposium. Though not claiming any unique insight into the timing or magnitude of the next rate increase, it is clearly going to be sooner rather than later. While the current confusion in the markets will need to be factored in, the Fed’s job, as Esther George (President of the Kansas City Fed) put it, “will be to separate the noise from the fundamentals.” Having said that, research presented by Goldman Sachs indicates that, on average, following periods of market volatility, the next Fed Funds rate increase is likely to be 15BP less than projected. Certainly, the conditions we have witnessed in the past several weeks make a September increase less likely.
So far, there are few indications that the current market turmoil is likely to spread to the real economy. However, this could change if it persists. Memories of the events of 2008-2009 are still fresh in many investors’ minds and it is all too easy to conjure up the gut wrenching declines in global economies and equity markets we witnessed during that period.
Historically, the so called ‘wealth effect’ has shown that for every 10% decline in stock markets, the U.S. has had a .2% decline in GDP, as consumers bring in their horns. They say the saying “it’s different this time” are the four most dangerous words in the English language, but in this instance I think it is the case. In the U.S., neither the corporate sector nor the consumer is over extended, the U.S. economy is stable and growing, and the rest of the world is generally intact.
While I do not believe equity valuations in the U.S. have declined to the level where bargains abound, there are certainly companies, for instance, in the financial and media space, which are starting to be good value. Outside the U.S., the picture is rosier, with Europe offering good value, especially when its high dividend yields are taken into account. Emerging markets in particular have been severely punished, and selectively are starting to look interesting.
In short, as we see it, the recent market turmoil does not reflect fundamentals, either from an economic, or a corporate, point of view. While the current declines are painful and we do not anticipate a quick rebound, for long-term investors their impact should be minimal and pockets of value are starting to appear. As always, diversification across asset classes and geography represents a useful form of risk control.