In our view there have been two main drivers: the first being that it has been seen as increasingly likely that US interest rates will begin to rise, possibly as early as September, after years at current extremely low levels. While the level of such a rate rise, if it were to happen, is unlikely to be large, it sends out a signal to the effect that, at least as far as the US is concerned, the era of ultra- low interest rates is drawing to a close. This in turn has the potential for a global knock-on effect, particularly among emerging markets where currencies and economies are extremely interest rate sensitive, and are likely to be damaged by the stronger US dollar that is likely to emerge.
This leads directly to the situation in China which, behind the USA, is by far the World’s second largest economy. To talk of such an economy as being ‘emerging’ is therefore a considerable misnomer, but nonetheless the Chinese economy continues to carry many of the hallmarks of what are generally regarded collectively as ‘emerging markets’, in large measure because China’s huge population is looking to see personal benefit (as living standards remain low for very many) from China’s huge growth over the last twenty years or more.
What is clear is that Chinese growth rates are slowing. The Chinese Government, with its fixation around continuing to ensure that China is a ‘controlled’ economy, appears not to have faced up to the increasing probability that their 7% annual growth objective cannot continue to be achieved, and indeed in all probability, real Chinese GDP growth is below that figure.
However, Chinese efforts to bolster the economy have included weakening their currency to make exports more competitive. They now target a ‘market orientated’ foreign exchange price setting approach which has opened the flood gates towards a more realistic currency valuation. In order to keep this process orderly, People Bank of China has drawn significantly on its massive foreign exchange reserves to try to control the market driven adjustment process.
Further, a substantial speculative bubble has emerged in Chinese equity markets, fostered to a significant effect by the availability of borrowed money enabling and encouraging Chinese individuals to buy shares. Many would argue that recent Chinese stock market falls are nothing other than a healthy correction in response to the bursting of the bubble built up over the last year, but investors linked to the Chinese state have been encouraged, or possibly been obliged, to seek to prop up share prices through the simple expedient of making massive share purchases. All that this has achieved, however, is the production of a further weight of selling and it appears that in recent days Beijing has capitulated, in that this buying has stopped, leaving quasi state institutions nursing heavy losses as this support for the market has been removed.
The net result of all of this is that, yet again, Chinese interest rates have been cut in an effort to stimulate growth (and borrowing levels are already high) and, arguably, the Chinese authorities are perhaps gaining a better sense of the limitations of state control when faced with the power of global markets. Indeed, the authorities may also have failed to fully recognise and accept the economic slowdown. As a result their reactions have been slower than might have been and in the process not aiding the effective change of direction within the Chinese economy from that of one dominated by low cost manufacturing to one where the Chinese consumer expects to see, and to be able to spend, the fruits of their labours.
In our view, the consequences of all of this are likely to be a degree of slowdown in China’s status as a global growth engine which in turn has put pressure on raw material prices as demand from China for them slows down. This clearly has a significant impact on companies with large exporting businesses to China, whether that be, for example, metals, oils, or, at the other end of the spectrum, luxury goods.
Germany is a major exporter to China and as such may more directly feel the impact of the slowdown. Elsewhere, the impact will also be felt in a range of economies, including those heavily dependent on raw materials (eg Australia, Russia and Venezuela).
We may expect to see further downward pressure on inflation globally as a result of lower raw material prices, while to the extent that China in effect cuts export prices, there is potential for it to export deflation to other economies. This matters in particular as inflation pressures are one of the key potential drivers towards higher interest rates, which is of course the topic with which this note commenced. As a consequence, however, it seems less likely that interest rates will rise in the USA early this Autumn (it had been widely expected previously that they would) while rises in the UK may now be pushed out to next Summer.
All of this suggests that the growth in company profits, particularly in certain sectors, is likely to come under pressure. We do not however translate this into expectations of a profit slump (except among raw material producers where this has already happened). In the meantime, very many companies have taken considerable advantage of persistent low interest rates to strengthen their balance sheets and to lock into cheap money to finance medium and longer term operations in a way that will stand them in good stead well into the future. It is increasingly likely that fixed interest markets will stabilise at around current levels for longer than previously anticipated.
Emerging markets have become higher risk areas for investors than previously considered to be until only quite recently.
We do not consider the market correction that has taken place in recent weeks to be the precursor to a more significant crash in equity markets and when set against the overall gains seen over the last five or six years, the falls look relatively modest. While it may seem counter intuitive, setbacks such as we have seen often provide what are, when viewed with hindsight further down the line, excellent opportunities for long and medium term investors to add to their equity portfolios.