Chinese Wall of Worry
“The key to making money in stocks is not to get scared out of them.”
Bears took over last week, but, as of this writing no “Black Swans” have surfaced and despite sharp downward moves in the averages, the correction remained orderly. Technicians are claiming a broad assortment of negative formations, media and CNBC are parading the permabears, and according to strategists, this selloff was a necessary prerequisite for the continuation of the six year bull market. To others this long overdue correction is a precursor to a global recession. After flirting with a 10% correction last Friday, all major averages fell sharply into negative territory at the opening on Monday. In trading resembling “flash mistakes” of the past, the market whipsawed a minimum of 300 Dow points four times in the first half hour. The VIX reached a high of 53 briefly, a level not seen since early 2009. A rally held into early afternoon, but by the close all major averages were well-below Friday and off their record highs with the Dow down 13.5%, S&P 500 -11.3%, and the NASDAQ -13.5%, all clearly in correction territory.
The Chinese Government, working through the People’s Bank of China (PBOC), on August 11th initiated a flexible currency policy devaluing the yuan 2%. The following day the yuan fell an additional 2%, but the sale of dollars orchestrated by the PBOC near the close of trading cut the decline in half. Since then the yuan has remained at these levels with PBOC interventions. Obviously, the new currency policy is part of a longer-term plan by the Chinese Government to reach a market-oriented level for the yuan. Stock markets in Europe and the United States sold off as the extent of the currency adjustment remains unknown and on speculation of the weakness of China’s economy. Recent data, released over the past two weeks, point to a more rapidly deteriorating economy, much worse than had been assumed. We believe that China’s devaluation is the appropriate policy as part of an overall economic stimulus. Since the yuan was pegged to the dollar it appreciated about 14% over the past year against the currencies of many trading partners. With exports falling and overall growth rapidly slowing, the PBOC has begun its own form of QE. China can be expected to further weaken the yuan, but at the same time must be careful to avoid a free fall.
To base future investment strategy on what is happening in China is both impossible and unnecessary. For US investors the implications of a China slowdown are clear, lower commodity prices. It has long been known that economic data from China are unreliable and therefore difficult to ascertain if China is experiencing a slowdown or an outright recession. GDP growth is officially 6%, but the “Beijing Whisper Number” is 1.5%-2.5%. So much for a closed economy. One thing is certain, the oversupply of nonagricultural commodities ranging from metals to oils is directly related to falling demand from China. We would not expect equilibrium until there is a sizeable reduction in commodity producers, most likely by default or bankruptcy. Despite the recent dialog by market bears, the effect on the US economy is marginal at best; US exports to China are less than 1% of GDP. Our imports are primary materials and contracted goods sold around the world under US company brands. Prices of these branded products will decline with a depreciating yuan, perhaps complicating the normalization policy on the data dependent Fed.
China’s problems are well-known and the Fed is going to raise rates sometime in the future. China is one of the few countries with monetary options in its arsenal and has only starting utilizing them. Today, for the second time in two months, the PBOC lowered interest rates and bank reserves, this should be interpreted as a move to stimulate the China economy, rather than support for the falling Shanghai Stock Market. Accompanying the Chinese devaluation has been an accelerated depreciation throughout the Asia-Pacific region’s exporting countries. Lower real interest rates and the push for infrastructure in China resulted in many of these countries overestimating growth and falling prey to excess investment. Deteriorating overall productivity and misallocation of capital surfaced with China’s slowdown. For the region a prolonged adjustment cycle will require a restructuring of past misallocations and reducing new investment. These Emerging Market policy makers are hindered by deflationary risks in a low or no growth environment, making it difficult for transition to a new growth cycle. However, a positive is this current account surplus for most Asian emerging countries, with only India and Indonesia in deficits of under 2.5% of GDP.
For Fed watchers, the devaluation creates confusion for timing a second-half interest rate increase. As markets approach the inevitability of the overly anticipated increase of the Fed Funds rate, the rhetoric of these “Feders” and the business press will intensify. The 10-year Treasury yield is now below 2%, reflecting a flight to safety from foreign currency denominated assets. The Fed’s move to rate normalization will be influenced by currency destabilization and falling inflationary expectations from lower commodity prices. It is the resiliency of the US economy that argues for a 2H2015 rate increase. We feel confident in the Fed and are agnostic to the timing, certainly they know better than anyone when to initiate the interest rate rise. Not unlike Y2K, the increase in interest rates will pass without chaos to markets and the bears will swiftly shift gears and speed forward to the next perceived crisis.
The current US economic recovery, now over six years in duration, remains subdued, but positive. Across the rest of the developed world, for Europe and Japan growth continues, but below US levels. Today, the global economy, or more specifically, resource-dependent emerging market countries, are experiencing recessions as raw material prices have fallen. For the BRIC’s (Brazil, Russia, India and China), only India remains unaffected. Brazil is in recession, real GDP is forecast to fall 1.7% in 2015 and prices are rising nearly 9%. Lower oil prices and a 28% decline in copper over the past year have sent Brazil spiraling downward. Russian dependence on energy exports (50% of gov’t revenues) is well-documented, but it has been the sanctions related to their “annexation” of Crimea and the further intrusion into the Ukraine that has sent the country into a deep recession. With real GDP estimated at -3.6% for 2015 and prices currently rising at 15.9%, the ruble has deprecated 45% against the US dollar. As mentioned, China’s economic pivot away from infrastructure overgrowth to a consumer economy has further reduced demand along the Pacific Rim for iron ore, coal and copper. We expect the supply/demand imbalance to continue throughout the World’s commodity exporting countries.
The US economy has added net 4.6 million jobs since the beginning of 2014 while real GDP averaged 2.2%. The closely watched Employment Cost Index (ECI) rose 0.2% in 2Q2015 and it is unlikely that any reports between now and the September FOMC meeting will present data in support of rising income. More importantly, whenever the Fed moves without inflation long-term rates do not rise, but with short-term rates rising slowly, the yield curve does not invert. With raw material prices still seeking a bottom and plagued with excess capacity worldwide, both consumer and wholesale prices remain below 2011-2014 levels. For US consumers, both business and households, the savings from a sustained period of lowered gasoline and heating costs are being used to offset additional health costs and higher rents. The new paradigm of renting rather than purchasing has resulted in a shortage of quality rentals. With low inventories home prices are rising, and along with strict mortgage requirements ensure a continuation of the rental trend. As we move further along the business cycle, housing will provide stability to growth as a “normal housing market” adjusts to tighter regulation and changing demographics.
To US investors, the recent earnings season, although better than estimated prior to its start, gives no clear picture to 2H2015. In fact, any upside to the Energy sector has been reversed during the recent drop in crude prices. According to FactSet, with about 90% of the S&P 500 reported, “73% have reported earnings above the mean estimate and 51% have reported sales above the mean estimate.” An indication of the circumstances affecting 2Q2015 earnings is revealed in a survey of Conference Calls of 415 S&P 500 companies by FactSet. The terms most used by companies show: Currency (56%); Europe (53%); China (44%); and Energy (42%) as the order of relevance. As we are now nearly two months through 3Q2015, a strong US dollar remains a problem for multi-national companies and a broadening segment of the S&P 500. At current levels the yuan will only marginally impact US exports to China for those companies already dealing with a slowing Chinese economy and a stronger dollar elsewhere. Earnings from the current quarter are shaping-up as a replay of 2Q2015.
Markets remain vulnerable as investors and traders assess the outcome for China, falling oil prices, a stronger dollar, and fluctuating interest rates. In the short-term, there is potential for a further selloff offering a tactical buying opportunity. Once the Fed raises rates, stocks should perform well during the rate normalization process. Longer term we believe that moderate economic growth, accompanied by slow rising real interest rates and low inflation, will result in increased earnings and multiple expansion with continued upside for equities. Our investment policy remains optimistic on selective large-cap domestic corporate equities.