The Market Rides The Volatility Wave - What To Know About China

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Includes: CHN, CN, CNY, CXSE, CYB, FCA, FXCH, FXI, FXP, GCH, GXC, JFC, MCHI, PGJ, TDF, XPP, YANG, YAO, YINN, YXI
by: Manning & Napier

U.S. equity markets got off to a rough start in 2016. During the first week of the year, major domestic indices were down around 6%, with the S&P 500 registering its worst five-day performance to open a year in history. Volatility continued last week. As with the market downturn last summer, China was at the center of discussions about equity market performance.

Winston Churchill famously said Russia was "a riddle, wrapped in a mystery, inside an enigma," and that characterization could be applied to China today. It is difficult for anyone to fully know all the facts about China's politically-controlled economic system given the shroud of secrecy and opacity maintained by the Communist Party of China. Recent market concerns center on current and projected economic growth, currency moves, and the performance of China's stock market. These things are certainly interconnected, but evaluating them separately in the context of recent events can help explain what is occurring in China and how it is impacting global equity markets.

China's Stock Market

What has happened?

Chinese stock markets have fallen by approximately 20% this year.

What is the concern?

That the market decline is an indication of increasing weakness in the Chinese economy.

What do we know?

  • When media discuss the Chinese stock market, they are referring to the A-Shares market, which is the domestic market restricted to Chinese investors.
  • These investors are largely unsophisticated, as retail investors can account for up to 85% of the volume in the A-Shares market.
  • However, only around 10% of Chinese invest in the stock market, meaning it does not represent a large part of Chinese savings.
  • Historically, government policy decisions have driven the market and large speculative rises and falls have been fairly common. Company fundamentals have not been and still are not the main drivers of returns in the market.
  • Since last summer's market volatility, the government has implemented various measures to stabilize the market, such as a ban on stock sales by large shareholders and circuit breakers to manage volatility when it does occur. It also has been gradually removing some of these measures and gauging the market's response.
  • During the first week of the year, the ban on stock sales by large shareholders was set to expire, and investors tried to front-run that event, triggering a market decline.
  • In the wake of these events, the Chinese have revised their stock market trading rules.

What is the bottom line?

The A-Shares market has always been and will continue to be volatile. Nevertheless, it is not and never has been a good barometer of conditions in the Chinese economy.

China's Currency

What has happened?

The Chinese government entered currency markets during the first week of the year to guide the exchange rate of the renminbi (or yuan) to its lowest level in five years versus the U.S. dollar.

What is the concern?

That the government is pushing the renminbi lower in order to prevent the economy from suffering a hard landing, and that a large Chinese devaluation could cause a major economic crisis in other emerging markets.

What do we know?

  • Last summer, China announced policy changes that gave markets more control over the renminbi's exchange rate. Previously, the government would set the rate each day mostly by edict.
  • China's desire to have the renminbi included in the basket of currencies that make up the International Monetary Fund's Special Drawing Right (SDR), a supplementary international reserve asset, largely drove the decision to make the renminbi's exchange rate more market-driven.
  • China views being in the SDR alongside the dollar, euro, pound, and yen as recognition of its importance and influence in the global economy.
  • China no longer wants the renminbi pegged solely to the dollar. The new target of currency policy is the trade-weighted exchange rate, which takes into account the currency movements of China's major trading partners.
  • Relative to the basket of its major trading partners outside of the dollar, China's currency moves have not been out-of-line with its peers.
  • As part of the government's efforts to have a more market-oriented economy, the Chinese have been opening up the previously closed capital account-in effect loosening restrictions on how much money can leave the country. As previously "trapped" money now has a way to leave the country, the Chinese currency has recently seen net outflows, and that has acted to put downward pressure on the renminbi.

What is the bottom line?

China's transition to a more market-oriented economy involves a degree of trial-and-error, including in regard to managing the renminbi. The see-saw of currency moves has raised concerns among investors and has caused volatility in global markets. However, the Chinese government knows that a sharp devaluation of the renminbi would not be well-accepted by foreign governments, and would also be seen as a sign of potential instability. This would conflict with their efforts over several decades to cultivate the image of being a stable, responsible global economic power. A large devaluation would also make it much more expensive to service their dollar-denominated debt. Therefore, a sharp and uncontrollable currency devaluation would not serve the government's current political, economic, or financial interests, even though it would act to spur the economy given China's position as the world's largest exporter.

China's Economy

What has happened?

The growth rate of the Chinese economy has been slowing for some time. The economy rebounded from the global financial crisis to post 12.2% year-over-year growth in real GDP during the first quarter of 2010. Growth has since declined to 6.9% year-over-year in the third quarter of 2015. This is part-and-parcel of the transition the government is trying to engineer from an economy driven by investment to one more reliant on services and consumption.

What is the concern?

That managing a smooth transition proves too difficult for the government and the Chinese economy has a hard landing.

What do we know?

  • The transition in the structure of the Chinese economy has been occurring for some time.
  • This has caused growth to decline, but if the government can successfully manage the change, it ultimately should result in a slower-growing but more stable economy in the mid- to medium-term.
  • The growth rate of the services component of Chinese GDP has been rising, while the growth rate of the industry component has been declining. This has been particularly true during the last couple of years. Since the end of the second quarter of 2014, when the services component and industry component had year-over-year growth rates of 7.6% and 7.5%, respectively, the services component's rate has climbed to 8.4% versus a decline to 6.0% for the industry component. This suggests the government has had some success shifting the focus of the economy.
  • Despite having a currency that has appreciated by more than 25% over the last decade, the Chinese have significantly increased their market-share of global exports, implying that their levels of competitiveness remain world-class.
  • China recently recorded its largest ever trade surplus, bringing more than $600 billion into its economy. This makes the economy one of the least-vulnerable to a potential currency crisis, especially given the country's foreign reserves remain large, standing at $3.3 trillion.

What is the bottom line?

The growth rate of the Chinese economy moving forward will be lower than the sky-high levels to which the world became accustomed. We acknowledge this slower growth, but it should result in a more stable economy in the mid-to medium term.

Conclusions

Knowing for sure what will happen next in China is a tough task given the lack of transparency in terms of government policies and some economic data. Having said that, we think China's economy will continue to slow, but that the government will use fiscal and monetary tools to stimulate activity should the economy slow too much. Ultimately, the government should be able to manage the transition to a more market-oriented economy. This should keep overall reported growth on a path that is reasonably close to centrally-planned targets, although we continue to have a bias that growth might come in weaker than expectations. Nevertheless, we acknowledge that there likely will be missteps along the way, and these missteps could contribute to market volatility.

Our responsibility, in the face of potential volatility, is to consistently examine the individual companies in our portfolios to ensure they continue to represent strong investment opportunities for our clients. As volatility presents itself, we will seek to buy good companies at times of price weakness, and sell holdings if new information weakens our investment thesis, if a stock rises to our sell price, or if we encounter better investment opportunities. With respect to China, the country's overall health will likely continue to impact the performance of global equity markets. It will be important to understand these broad, macro-level events, but even more important to understand the fundamentals of individual stock opportunities both within and outside of the United States. We continue to hold several Chinese companies in our portfolios that allow for non-U.S. equity exposure.