By Constantin Gurdgiev
Stock and bond markets have been rocked on the waves of volatility, the doom of deep corrections and the highs of rapid reversals. The summer of 2015 will go down in history books as a period when the markets have finally reverted to pricing in real fundamentals. And the process of market ‘normalisation’ is proving to be a disruptive one.
After years of living on the hopium of endless easy money pumped into the economy by central banks and governments, the markets have finally started to embrace reality: in the eighth year of the fabled global recovery, economic growth around the world is faltering.
The August bear correction in the global markets was not the first alarm for investors. And it won’t be the last.
The first signs of a deep rot in the global economy registered as the 2013-2014 move by investors out of Emerging markets and a dramatic uplift in demand for lower risk assets, such as Government bonds. By mid-2014, clouds over emerging markets had spread to corporate bonds, with flash sell-offs and increased volatility hitting lower-grade junk bonds. The storm rolled on to the commodities markets with oil setting into a precipitous decline in mid-2014, followed by other industrial commodities and agricultural staples.
By early 2015, there were tremors hitting European Government bonds. Currency valuations shook. In May-June, a wave of volatility hit the sovereign bond markets, as ECB purchases of Government paper resulted in a dramatic widening of spreads and the fear of markets seizing up. Corporate debt caught the flu with dramatic increases in risk assessments for global corporate bonds.
All along, trouble was brewing in the Far East: global trade was falling off the cliff, largely unnoticed in the mainstream media. The Chinese growth engine was stalling and the Asia-Pacific region was swept by repeated rounds of currency devaluations.
Finally in August a massive blowout in stock markets, triggered by a collapse in Chinese shares prices, drove panic across both the advanced economies the emerging markets. On August 24th, after weeks of historically anomalous volatility, the Shanghai stock exchange fell almost 8 percent, with the Nikkei, EuroStox 500 and S&P500 all erasing on average just under 5% of their valuations.
By the end of the month, massive volatility in the markets around the world pushed share prices into recovery. Still, Shanghai was down 12 percent, the US S&P was off 0.1 percent, Japan’s Nikkei shed over 4 percent and the EuroStox index was 1.5 percent lower.
At the time of the market nadir, global equity falls had erased some $5.7tn of paper wealth. All in, August ended with the S&P down 6% marking the largest monthly drop since May 2012; the EuroStoxx had fallen 8.5%, the index’s worst performance since 2011. The FTSE is down around 10% while the ISEQ lost next to nothing.
Market turmoil was so sharp that the VIX index, a gauge of investors fear, reached its highest level since 2011 at the end of August, while a broad basket of agricultural and industrial commodities hit its lowest level since the start of the century. Oil dropped to its lowest level since 2009, down almost 50% over the last 12 months and 22% since June’s high. Copper hit a six-year low on August 24th.
China’s devaluation of its currency on August 11th sparked forest fires across the market. Contagion quickly spread to its core trading partners, such as Japan, South Korea, Indonesia, Malaysia and Singapore. Having devalued the yuan by some 5 percent overnight, the Chinese authorities made matters worse by subsequently aggressively intervening in the markets, selling US dollars and buying Chinese stocks.
All told, estimates from market analysts suggest that China sold more than $100bn worth of US Treasuries to partially fund foreign exchange interventions and stockmarket support measures, within just two weeks between August 12th and August 26th – more than it did in the previous eight months combined. This put fear into the $64 trillion worldwide bond markets: as equity investors rushed into the safety of US bonds, sell orders were flooding in from the largest international holder of Treasuries, China.
Some Financial Lessons to be Learned
The ‘China Tremor’ taught us several valuable lessons.
The first one was that global investors should not count on Chinese authorities to mind international markets corner.
Throughout the entire crisis, Beijing’s sole concern was, and remains, insulating the Chinese economy from spillovers from market turmoil. In the process of pursuing this goal, China is willing to go to currency war, as well as deploy a range of measures aimed at curbing trading that cuts across its objectives.
The second lesson is that Chinese markets – no matter what their direct impact may be on individual economies – are systemic to global finance.
In a sign how interconnected the markets and investors’ strategies are in modern financial environment, consider the following dynamic. When Chinese authorities started selling US Treasuries to defend the yuan, many institutional investors worldwide were holding so-called risk-parity portfolio positions. This strategy involves borrowing heavily to invest in low-volatility assets, such as advanced economies’ Government bonds. The return to such bonds tends to countermove with stocks returns, so booming stock markets imply shrinking bonds returns. But leverage (borrowing) allows investors to bring their profits closer to those that can be earned by holding much riskier equities.
Thus, at the end of August, many institutional investors worldwide were banking on a continued negative correlation between stocks and bonds returns, along with low volatility in bond prices.
Once China started selling US Treasuries, three things happened: bonds prices moved down in line with falling share prices; bond prices became more volatile; and leveraged funds were forced to cover mounting losses. A sell-off of risky assets across global markets ensued to cover the latter.
The third lesson is a forward-looking one: given the Chinese Government’s commitment to support economic growth, the pain of the Chinese economy’s adjustment to the new realities will be borne by China’s trading partners.
The problem here is that the only way China can continue supporting its economy and domestic stock markets is by abandoning its defence of the yuan. This means that the recent yuan depreciation is just the beginning of a longer and more painful process of competitive currency devaluations across the Asia-Pacific region, and beyond. And that will result in renewed deflation in commodities prices around the world, and the associated deflationary pressures.
The realisation that this is the likeliest scenario is behind the miraculous ‘recovery’ in the advanced economies markets since the end of August. Before the Chinese market collapse roughly 50-55 percent of global investors were expecting the US Fed to start hiking rates in September-October this year and for the ECB to end its Quantitative Easing (QE) around the third quarter (3Q) of 2016. Following the ‘China Tremor’, the percentage is now closer to 25. Western investors are increasingly projecting a Fed rate hike to come in December or later, while there is emerging talk in the markets about the ECB extending and expanding its QE.
Which brings us to the main lesson from the August blowout: no market is an island. This lesson remains alien to EU authorities which were making outlandish claims during the last days of August that Europe had erected functional ‘firewalls’ against global market contagion. The complacency was exacerbated in Ireland by Government and media effectively sleeping through the May-August period of volatility.
It’s the Economy, Stupid
Following relative calm in the markets in the first days of September, investors have been trying to gain some understanding of the August sell-off. Much of the analysis agrees: a hard landing in China will rival the impact of the US Great Recession on the global economy. Even usually out-of-touch Irish politicians are staying pretty silent on the prospect, if they’ve noticed it.
For China, ‘hard landing’ implies economic growth falling 3-4 percentage points below the 7 percent average annual expansion target for 2015-2016 set by the Chinese authorities. While official figures from Beijing suggest the economy is likely to achieve growth in the range of 6-7 percent this year, many analysts are arguing that it is already at the ‘hard landing’ mark.
The reason why such an outcome is likely to spell trouble for emerging markets and advanced economies is that recent global growth trends have been heavily reliant on Chinese demand for either inputs into production (raw commodities and semi-finished inputs, capital goods and technology, financial capital and professional services) or finished goods.
For example, in 2014, the top ten luxury-brand holding companies in Europe relied on China for roughly one third of their global sales. Chinese buyers accounted for up to 49 percent of global sales for some European brands, such as Swatch. Over 20 percent of Apple’s smart watches are sold to Chinese customers.
Simply put, China has been one of the core drivers of global growth over the last two decades, and the dominant one since the onset of the Great Recession in late 2007.
Zooming in to the present, Chinese exports have been falling in recent months, just as China’s imports from neighbouring countries have fallen through the floor.
South Korea – the world’s biggest exporter to China – saw its factory shipments to its neighbour collapse 15 percent in the year to August 2015, marking the eighth straight month of declines. South Korea supplies capital and intermediate goods to China, so a collapse in its exports is an unambiguous sign of a rapid slowdown in Chinese manufacturing.
To make things worse, the Chinese economic slowdown is not an isolated event. For example, based on Purchasing Manager Indices (PMIs) – a gauge of manufacturing activity – the Chinese economy has been stuck in a growth soft patch since late 2011. The start of the latest bout of outright contraction in the sector can be dated back to Q3 2014. Meanwhile, the services sector, stripping out financials, has also been lugubrious since around Q2 2013.
Over the seven months from January to July 2015, composite PMIs for BRIC economies (Brazil, Russia, India, China) imply virtually zero growth in the world’s largest emerging markets. Back in 2002 emerging markets’ annual rate of real GDP growth was about 2.75 percentage points higher than that in the advanced economies. By 2009 the growth gap peaked at 6.5 percentage points. Ever since then, the emerging markets growth premium has been on the decline, dropping to roughly 2002 levels in 2014. The gap is expected to end at just 2.1 percentage points this year.
Brazil and Russia are now in official recessions. As are Indonesia and Canada. South Africa is one quarter away from entering one. Switzerland avoided a recession this year only by squeezing miraculous 0.2% growth in 2Q 2015. According to a growing number of analysts, Australia is heading for a recession.
Drivers for this development are multiple, but amongst the most important ones are the following:
• Weak consumer demand in Western economies, where recovery has been driven primarily by the financial assets boom, rather than by domestic demand (consumption and investment) growth;
• Rounds of QE-induced devaluations of core currencies, such as the US dollar, euro and Japanese yen have triggered currency wars across the world
• The prospect of higher US interest rates is weighing heavily on the global economy.
Propelled by the above factors, Emerging Economies’ currencies have now fallen to their lowest levels in over 15 years, resulting in a precipitous decline in the dollar value of bonds and stocks denominated in these currencies. Hence, the broad MSCI index of emerging markets shares is now down roughly 10 percent on 2009, while advanced economies’ markets indices are up, on average, by some 50 percent. Based on data from Bloomberg, emerging markets are trading at a 30 percent discount to developed markets, the largest gap in 10 years.
The prospect of the US Fed reversing its policy and raising rates is a daunting one for the global economy. Between 1992 and 2000, historically lower interest rates in the US and Japan fuelled significant capital inflows into emerging markets. The series of currency crises in the second half of the 1990s unwound some of these excesses. Subsequently, from the end of 2001 until early 2007, a large credit bubble in the G3 economies (the US, Japan and the Euro area) pushed more investment into t emerging markets.
Starting in July 2008, the new era of exceptionally low interest rates has reinforced this trend. As Western investors borrowed in their home markets to invest in developing economies, their returns became fully underpinned by what is known as carry trades. In a classic carry trade, an investor borrows at low interest rates in her home currency and invests in a higher-interest-rate currency-denominated assets abroad. As long as the investment generates real returns in the home currency that are greater than the cost of borrowing, the investor remains content. However, if the home currency strengthens or domestic interest rates rise, the carry-trade investment becomes exposed to a risk that the investor will not be able to repay the original loans.
What we have now is a combination of a decline in market returns on top of the classic currency risk involved in a carry trade compounded by the prospect of US rates moving up. The result – trillions of dollars worth of investments raised through carry trades are now at risk.
The Key to the Future
The key question, therefore, is whether or not China is set for a deepening economic crisis or if the recent markets tumult was a temporary correction.
On the surface, the Chinese economy does face severe problems, with external trade taking a beating, while the domestic economy is weighed down by rapid acceleration in non-performing debt and slowing domestic investment.
The good news is that Chinese stock markets have little connection to real economic fundamentals on the ground. Chinese share values amount to just under one third of the country’s GDP, a third of the weight of advanced economies’ equity markets in their domestic economies. Over the 12 months to June 2015, Chinese stock prices nearly tripled in value, just as the real economy was running along the weakening trend. Stock-market-related lending had been rising very rapidly before August, but it still only amounts to 1 percent of the country’s total banking assets.
The real trigger for a Chinese economic ‘perfect storm’ will more likely be the country’s property markets.
Just as in Ireland in 2006, in China today property accounts for virtually all collateral against which the sizeable mountain of household and corporate debt has been extended in recent years, reaching as high as 250% of the country’s GDP, double what it was just eight years ago. To make matters worse, house prices have been rising, not falling, amidst the financial markets’ rot.
New construction and broader real-estate investment have nowhere to go but down, as developers and banks are sitting on massive inventories of unsold properties. Outside private investments, local authorities’ debt that ballooned in recent years is holding down public investment in infrastructure.
Central Government budgetary dynamics, however, suggest that there is substantial room for fiscal policy supports in the months ahead. For the full year, Beijing was originally planning on a fiscal deficit of 2.3 percent of GDP. So far, in the first seven months of the year, it has been running a fiscal surplus. This means that the central Government has sufficient funds to significantly ramp up public spending into 4Q 2015.
Monetary policy offers further room for manoeuvre. Despite a number of cuts through the end of August, the benchmark 12-month lending rate is still high at 4.6 percent, as compared to virtually zero in Western economies. Chinese banks are required to have a reserve deposits ratio of 18 percent, as opposed to around 1 percent for the majority of Western systems.
In the longer term, China can pursue serious reforms – in goods and service markets, public services and investment, labour markets, regulation, and so on. The list of reforms overdue is longer than that for Greece.
But, the key point of the markets’ performance over the summer flows well beyond the country’s financial and economic borders. They are a reflection of the global economy’s poor health.
China has just completed several decades of growth fuelled by investment. Capital formation and the build-up of physical infrastructure has accounted for roughly half of Chinese GDP growth over the past two decades.
Today, this means surplus capacity, as global economic growth cannot sustain all the machinery, factories, land and resource reserves accumulated by China, but also by a number of other states, including Australia, Canada and even the US.
Any country, like Ireland, heavily dependent on multinational investments and exports should be worried. •