MARKET BULLETIN 25 AUGUST 2015 COMMENTARY // AUGUST 2015
STOCKMARKET MIST CLEARS... ONLY TO REVEAL AN ABYSS A sea-change has taken place in the world’s stockmarkets. Having been seemingly fog-bound for most of the year, unable to find direction or make headway, they have succumbed to fear and panic. It’s natural for investors to want to understand why markets move, especially when the movement is large. Perhaps by understanding what has happened we can derive some information that will help us predict what will happen next. Regarding recent stockmarket turmoil, however, that may be a pointless exercise. The movements have been so rapid and extreme that they defy explanation. It is always tempting to imbue capital markets with a higher knowledge, to assume that they have some kind of predictive power that will materialise in a new economic reality. But it would be wrong. What’s important now is our reaction, not the quest for an explanation. Our confidence in the rational behaviour of markets may have been shaken but our confidence in our investment process is intact. That process is telling us that stockmarkets are now cheaper, bond markets remain expensive but, crucially, the state of the world has barely changed. Such change as there has been, concerns Emerging Markets (EM) and, in particular, China. Two weeks ago China’s central bank spooked markets by devaluing the Chinese currency. The extent of the devaluation – a mere 4% – was not enough to cause much change in the economic landscape but the change of policy is important: China now has another tool in its arsenal for managing the economy. Markets seem to have taken this as implying that China’s economy is in a worse state than had been imagined. If that is the case, further devaluations may occur. We do not know when or how much - the People’s Bank of China is not accustomed to sharing information, and that creates uncertainty. If those devaluations were to occur they would probably be followed by competitive devaluations elsewhere among emerging nations. For this reason, yesterday we sold our remaining EM bond holdings. These were mostly US Dollar denominated, and had been relatively stable during the panic of the past few days. However, even they are ultimately at risk from further devaluation of the Chinese currency. This action raises cash of about 6% in our Balanced portfolios, bringing cash resources up to 15% of assets (the equivalent figure is 19% in Moderately Cautious and 7% in Moderately Adventurous). It also reduces our exposure to foreign currencies, now down to 15% in our Balanced portfolios. If stockmarkets continue to decline we plan to raise cash from other assets with a view to exploiting valuation opportunities. On the subject of China, we want to guard against surprises from an inscrutable central bank but we also see the glass as being half-full. If investors are supposedly concerned about a slowing Chinese economy they should be cheered by the policy of currency devaluation. One can hardly fault China for wanting a weaker, more flexible currency when so many other nations in the world have been actively devaluing their own! China’s economy has been slowing for years. Some of that slowdown is intentional, as the government seeks to rebalance the economy away from polluting heavy industry and construction towards services and consumer spending. The services sector now represents half the Chinese economy (see chart overleaf), up from 44% a few years ago, and is growing at a double-digit rate. The Chinese consumer is in great shape: retail sales are rising by 10% per annum. When it comes to soaking up this demand, Chinese companies are formidable competitors: when we hear CEOs complain about slow growth in China we should bear in mind that they are often just losing market share.
Source: Macrobond Moreover, the government has been actively managing the effects of the slowdown, addressing problems with local authority debt burdens and easing interest rates in a variety of ways. There are still many tools available to influence the economy, and the ability of the Chinese government to take robust actions that democracies would struggle to enact is one of China’s attractions. The Chinese housing market, another source of concern to foreign investors, is perking up. China’s Asian trading partners should benefit if China’s slowdown can be moderated but, being great exporters, they will also benefit from stronger economic growth in the US, Japan and Europe. Plenty of Asian companies are already priced for near-crisis, which we think is too pessimistic. That is why we have chosen to hold onto our Chinese and Asian stockmarket investments. These positions have performed very poorly over the past few months. In fact, they are principally responsible for undermining the good performance of our portfolios in the year so far. Our mistake was to underestimate the extent to which Asian currencies would depreciate. But this is not currency depreciation prompted by a crisis – it is the normal functioning of economies as they rebalance in the face of trade pressures. We have avoided those economies dependent on exports of commodities. The companies we have invested in have reasonable profit expectations, good dividend yields and attractive valuations. Profits will soon also be boosted by having costs in cheaper local currencies and revenues in stronger foreign currencies. It may be some time before other investors share our view but this is an opportunity worth waiting for. Despite chaotic markets, the global economic picture is reasonably positive, as good news from the US and Europe offsets bad news from commodities exporters and the oil industry. US growth expectations have slowed somewhat since the start of the year but, more importantly, the health of the US consumer continues to improve, driven by lower oil prices and strong labour markets. US corporate profits had been impacted during the year by the strength of the Dollar, but should return to growth in 2016. As exports to China represent only a small fraction of the US economy, even a very dramatic slowdown in China would not necessarily curtail growth. Incidentally, exports to all EM represent 2% of US GDP. The brightest spot in the global economy this year has been Europe, which continues to maintain its recovery, both in economic growth and in corporate profits. Europe is more exposed to China through its large export industry. Germany is the region’s main driver of both growth and exports: 8% of Germany’s exports go to China and a third to all EM. Meanwhile, however, the German consumer is in ebullient mood, with retail sales growing at their fastest rate for decades. Don’t be put off by markets – the world is not in bad shape. Chris Darbyshire Chief Investment Officer For more information call 0207 760 8777 or visit www.7im.co.uk Seven Investment Management LLP is authorised and regulated by the Financial Conduct Authority. Member of the London Stock Exchange. Registered office: 125 Old Broad Street, London. EC2N 1AR. Registered in England and Wales No. OC378740. The value of investments may fluctuate in price or value and you may get back less than the amount originally invested. Past performance is not a guide to the future. The investment service may not be suitable for all recipients and if you have any doubts you should contact your investment adviser.