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Equity markets saw exceptional levels of volatility in the second half of August on concerns over the state of economic growth in China combined with the prospect of an imminent interest rate rise in the US. There was a sharp recovery in the last week although it was still a disappointing month with few assets offering much resilience. We expect some further volatility and will invest only selectively.
The events in the month unfolded in stages. The first significant move came on 11th August when the People’s Bank of China (PBoC) announced that it would let the currency devalue by 2% against the US$, not a huge move in itself but an indication that it would end the peg it had kept in place for a number of years. This prompted fears that the Chinese authorities were attempting to counter a continued decline in exports and as such the move was a reflection both of economic weakness and a willingness to countenance a step-change in competitive currency moves. It might also be seen as part of the policy to give market forces more influence as part of a move to establish the renminbi as a reserve currency on a par with the US$. Further disappointing data and a continued decline in the Shanghai stock market unsettled other markets. There was another ‘Black Monday’ of sorts on 24th August as there had been no policy measures announced over the weekend and as it became clear that the authorities had accepted that their widespread efforts to stop the freefall in the Chinese stock market were fruitless (and they might instead have limited the margin lending that helped to drive it up so sharply in the first place instead of encouraging it as a reflection of the ‘China dream’).
The rally came as the PBoC both cut interest rates again and injected some further liquidity and as strong GDP figures in the US reassured investors. In the US economic growth for the second quarter was reported at a strong 3.7% and has prolonged the dilemma for the US Federal Reserve, which seemed ready to raise interest rates this year (and might yet) but is wary of the latest international developments. While the US makes only limited exports to China there are wider implications for the economy. The Chinese authorities have suffered from a loss of credibility having not managed events as well as they or most others would usually expect. The central bank spent money trying to stop the currency devaluing by too much (an estimated $200bn, which has eaten a little into the country’s substantial reserves which had stood at $3.65trn at the end of July). It also spent a similar amount in its attempt to prop up the stock market.
The issue has been less to do with China’s growth, which has been slowing for a while as testified by the price of most commodities (which have also reflected increased supply, whether from US shale in oil or extra capacity from major mining companies) and more the overall level of the world economy. It is important that companies are able to achieve earnings growth to justify valuations that have risen broadly in recent years by more than earnings. In the first two quarters of 2015 the annualised earnings growth for companies in the S&P500 was 2.2% and 1.3% and for the current quarter it might decline, due to the resource sectors and the strength of the US$. Companies have deployed strong balance sheets in making decent dividend payments, which have increased internationally at an underlying rate of 9% excluding special payments and the effect of currency. Companies have also been buying other businesses, a support to markets, and such corporate activity will be important in future months, as will sufficient confidence to increase direct investment – which has been a missing component of economic progress to date.
The outlook for the UK is still broadly positive although the level of unemployment again rose a little and Mark Carney, the Governor of the Bank of England, has shown patience on when interest rates might rise, suggesting it will be around the turn of the year. Economic data on the Continent has also been more encouraging and the Greek crisis has passed for now; the snap election called by Alexis Tsipras adds some short-term uncertainty but might establish a government with the authority to carry out the reform programme and cost-cutting that the current one agreed.
The outlook in Japan is more mixed and the country does face a challenge in competing with other Asian exporters, although domestic confidence and corporate profitability appear relatively robust.
The Russian and Brazilian economies are contracting and if the Chinese economy were to be growing at 4% and not the official rate of 7% then the overall level of emerging market growth would be under 3%, close to its levels during the Asian financial crisis in 1997-98. Having contributed to the increase in global trade after the recent financial crisis emerging markets are no longer doing so; weaker currencies appear not to have stimulated exports but have restricted imports as they become more expensive. Emerging market equities offer ever better value, it seems, but are not yet compelling.
As for market returns, over August the FTSE 100 fell by 6.7% to close at 6248 leaving it 4.9% below the level at the beginning of January (and 12% off its record level in April). The FTSE 250 Index of midsized companies was more resilient with a decline of -3.2% while that of the FTSE SmallCap Index was -2.4% (smaller companies can have a lagged reaction to market sell-offs although they are also a purer play on the strength of the UK economy). In the US the S&P 500 index was down 6.3% in the month and is off 4.2% for 2015 and while the technology-oriented NASDAQ index fell 6.9% in August it was just up for the year to date. In Europe the EURO STOXX 50 was down by 9.2% leaving it now up 3.9% for the year to date; shares in Germany suffered given the importance of exports to China. In Japan the Nikkei 225 fell 8.1% and the Shanghai exchange dropped a further 12.5% although it is still up 44.6% over the last twelve months. The MSCI Emerging Markets index in US$ fell by 9%: China and Brazil were weak, Korea and Russia relatively resilient. Bonds failed to offer any real support to portfolios as yields rose, most notably in Germany; that on the 10-year gilt went from 1.88% to 1.96% resulting in a dip in the FTSE Gilts All Stocks index of 0.5%.
Sterling first strengthened then weakened against the US dollar to end down 1.8% over the month at a rate of $1.53:£, and it was also weaker against the euro at €1.37:£. The price of a barrel of Brent oil fell to a six-year low of $42 before recovering sharply in the last days of the month to close at $54. Other commodity prices were relatively resilient over the month with copper down 1.6% although it is off 17.4% for the year to date. The price of gold rose 3.6% to $1135 per troy ounce which was perhaps lower than expected given the state of financial markets. However, the Vix index, a measure of volatility and also for some of fear in markets, reached its highest level since the eurozone crisis in 2011 before subsiding by half as markets stabilised.
While such volatility is in part a feature of the holiday season and while such a correction follows a typical pattern over the years, we are very mindful of the need for earnings growth to match expectations and for portfolios to match our own expectations.
Julian Cooke – Investment Director 1st September 2015, Vintage Asset Management
All views are the authors own and do not represent those of SG Financial Services Limited.
DISCLAIMER: Any forecasts, figures, opinions or investment techniques and strategies set out, unless otherwise stated, are Vintage Asset Management’s own. They are considered to be accurate at the time of writing, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. They may be subject to change without reference or notification to you. The views contained herein are not to be taken as an advice or recommendation to buy or sell any investment and the material should not be relied upon as containing sufficient information to support an investment decision. It should be noted that the value of investments and the income from them may fluctuate and investors may not get back the full amount invested.
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