Investors have had to hold on to their hats in what has been a bumpy ride to the start of 2016.
These first months of the year have seen Australian markets under strain from falling oil and commodity prices, an increase in US interest rates and a turbulent Australian dollar.
Investors have justifiably questioned the outlook ahead, and it is on China where many have set their nervous gaze. In 2013, Chinese authorities embarked on an ambitious reform program focused on government financing, corruption and the overall structure of the economy. Through 2015, it became clear that this was creating pressure on their economy.
Further to this, the move by Chinese authorities to depreciate its currency by another 1.5 per cent against the US dollar this year has many questioning whether the move signifies a weakening Chinese economy, while others are concerned it may trigger a global currency and trade war with uncertain consequences.
However, rather than brace for ‘World War Xi’, we believe the outlook is relatively positive for investors. Chinese authorities have begun to slow the pace of reform and have undertaken a range of policy measures to support economic growth. These actions are now starting to have an impact and could have an important influence on Australian resource companies, commodity prices and emerging market assets throughout this year.
We see the equity market moves as an over-reaction and retain a relatively positive view on markets for 2016. While the economy has no doubt slowed over the past year and we are sure to continue to see periods of high volatility, there is little evidence that conditions have deteriorated in recent months. We will discuss the reasons why we remain upbeat and have made no significant changes to our market forecasts.
From reform back to growth
At the recent National People’s conference, the Chinese leadership announced a change in the focus of its policy from reform back to supporting economic growth.
This has been accompanied by a range of policy measures, such as:
- The central bank has lowered reserve requirements for Chinese banks, allowing them to lend more. Indeed, credit growth has picked up sharply in the first two months of 2016;
- Restrictions on property markets transactions have been eased;
- Fiscal spending is set to ramp up. The Government has stated that it intends to fast track a number of large-scale infrastructure projects in the first half of 2016; and
- Margin lending restrictions on Chinese shares have been removed. This is an important development because Chinese households are very large holders of mainland shares.
It will take a while for these measures to boost activity, but there are some early signs that they are working. The manufacturing sector rebounded sharply in March and property sector activity has also lifted.
Housing is growing again as Chinese developers purchase land, while house prices are also higher. Chinese steel mills have also seen a big pick-up in orders.
Understanding the currency depreciation
Earlier this year, the Chinese authorities moved to depreciate their currency by around 1.5 per cent.
While this move will ultimately give a boost to the export sector, many believe it implies that the authorities are concerned about the current state of the economy.
We believe the currency move reflects an attempt to counteract the stronger US dollar. Since the Chinese yuan is linked to the US dollar, the sharp rise in the US dollar against the euro and yen has effectively dragged the yuan higher against these other currencies.
In response, earlier this year China announced the yuan would now be managed against a basket of currencies. The yuan has risen by about 30 per cent against this basket over the past few years. The recent depreciation should be seen as the first step in this new regime.
The lower yuan will ultimately be positive for the economy by boosting exports. However, there are risks involved with the move. Fears of a sharp depreciation have led to significant capital outflows from China. Corporates and households are attempting to avoid the losses associated with holding assets in a depreciating currency.
More than US$100 million per month is escaping, and China is being forced to liquidate its foreign exchange reserves to match these outflows. If these outflows accelerate further, they will place some strains on the financial sector. China will need to manage this situation closely. It may be forced to raise interest rates to deter capital from leaving, tighten capital controls or make a large one-off depreciation.
As such, we think a large devaluation is unlikely. Chinese exports have taken up an ever-greater market share in recent years despite the appreciation of the yuan.
Chinese exports have also historically been very sensitive to small changes in the yuan, so a large devaluation is probably not required.
Rising protectionism in the developed world will also make a large devaluation politically difficult. We think it is more probable that China will opt for a combination of intervention and incremental capital controls.
What history tells us about Chinese recovery episodes
We can turn to history to determine what an improvement in Chinese growth normally means for markets. There are a number of conclusions we can make from history:
- Global equities rally following Chinese stimulus. Australian shares outperform other developed markets, particularly resources, but the strongest equity markets are emerging markets. Latin American shares are the big outperformers given their resources exposure;
- Commodities rebound, which is unsurprising given that China is a major consumer of commodities. Base metals respond the most to Chinese stimulus; and
- The US dollar normally depreciates while the Australian dollar moves higher. Emerging Market (EM) currencies also appreciate.
History tells us that Australian shares, commodities and emerging market assets normally perform solidly around Chinese recovery episodes. But there are other preconditions for outperformance which have been met recently, particularly for emerging market equities. EM equity valuations are very cheap, earnings expectations have been rebased, commodity prices have ceased falling while the US dollar has stopped appreciating for the time being.
Outlook
Of course, there are longer-term challenges, which explain why investors have avoided these asset classes in recent times. China still has excess capacity in a number of sectors, commodity markets remain oversupplied and corporate debt levels are elevated. These have not gone away.
But despite this, we think that investors will gain confidence from the Chinese policy measures as they will act to put a floor under Chinese growth. As the year progresses, we expect the results of these policy changes will become evident in improving exports and consumption.
Further to this, the currency depreciation does not reflect a recent deterioration in the economy. Instead we believe it should be seen as part of a broad policy response to the weakening in the industrial economy, and as a means to ensure the economic transition to services happens smoothly.
As such, we are tactically positive on the outlook for Australian shares, commodities and emerging market equities.
Tim Rocks is the head of market strategy and research at BT Investment Solutions.
