The catalyst for these past few weeks’ turbulence in global stock markets clearly had a “Made in China” label. But what made it far-reaching was that it occurred at a time when global financial markets are already quite sensitive to news flow and event risk.
China has been simmering as a financial market risk for some time. The economy is clearly slowing but this shouldn’t come as a surprise to most investors.
However, one source of added disquiet was the tumble in Chinese equity markets which started in June. The Shanghai Composite index peaked in June this year – after a surge of 150pc in the preceding 12 months – but the most recent bout of selling has seen it drop by about 40pc from that peak.
This however did seem to be a contained risk and didn’t burden developed market equities too much through June and July.
The more worrying move for investors was the decision by Chinese policy makers to devalue the currency. While the actual move of around 3pc was minimal, what was more significant was what it implied about the health of the economy, coming as it did fast on the heels of weak economic data. What did Chinese policy makers see in the underlying economy that may have triggered their response? Further moves by the authorities such as channelling funds to the market and continuing to cut interest rates failed to give the impression of policy makers with a firm grasp on the problem or its solution. The lack of transparency into the workings of the Chinese economy together with the risk of a policy mistake provided little comfort to investors.
The ripples from the events in China impacted first on other Emerging Market assets and then spread to the major global stock markets.
The reason that that the reaction was so severe was that these ripples fell upon world equity markets which, if not necessarily priced for perfection, were probably not that far off.
Valuations in equity markets were fairly full but justifiable given a reasonable prospect of growth in company profits in 2015 and 2016, which is what analysts are forecasting. If this growth picture was threatened by a tumbling Chinese economy these valuation levels would look stretched.
The other source of sensitivity for markets is the fact that we are most likely in a period of transition to higher interest rates in some key regions. The US is likely to see its first rate increase since 2006 in the next six months. Some market analysts fear that a regime of higher rates will be a drag on stock markets given the huge run we’ve had with a benign interest rate backdrop.
However, the counter argument is that any move to increase rates is almost a “seal of approval” from the US Central Bank that the economy is back on track.
Also, policy makers are not going to squander the hard-won growth we’ve seen to date by a precipitous series of wanton interest rate hikes. This will be measured and sensitive to the underlying resilience of the economy.
Markets may well remain volatile as investors seek a clearer picture of just what is going in the Chinese economy and markets seek to navigate a path through what were already choppy waters.
What should investors do? Diversification across asset classes will always provide a buffer in times of market stress and reduce overall risk.
It is important that this diversification is dynamic and takes account of changing conditions – and that it can allow investors take advantage of market weakness when appropriate.
Investors should have an absolute return mindset, looking for those companies with quality characteristics like great cash flow, well covered dividend streams and strong balance sheets. These quality compounders tend to hold up much better in times of market stress, and protecting on the downside is a key pillar in long term investment success.
Eugene Kiernan is Head of Investment Strategy at Appian Asset Management. Appian Asset Management is regulated by the Central Bank of Ireland. The views expressed do not constitute investment advice.
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