China's New Export - A Market Correction

by: Principal Financial Group

By Mustafa Sagun, Chief Investment Officer, Principal Global Equities

China ahead Global equity markets had the worst start of the year, ever. Will they reverse course or is there more to come? While I believe this "bad start" may be contained for the time being, I do expect more volatility to come in 2016. Now's the time to build your portfolios to catch potential benefits from volatility or reduce downside risk along with upside participation. Surely equity markets can go up given positive earnings growth prospects, but it will likely be a rough ride. Let me first review the recent correction episode which was triggered by China concerns and then talk about potential sources of more volatility in 2016.

Recent Correction Episode

2016 started with a sharp sell-off in the China A-share market, sparked by concerns about slowing growth in China, the expiration of the selling ban on January 8th, and newly-implemented circuit breakers which are programmed to stop trading when the market is down 7%. Collectively, these events resulted in Chinese investors rushing out the door at the same time - ahead of the selling ban expiration. Complicating the issue was the $108 billion loss of reserves in December, which implied further devaluation of China's renminbi. The renminbi jumped from 6.50 to 6.60 in a matter of days and the offshore market renminbi jumped even more to 6.75, implying speculators recognized that further devaluation was likely and wanted to benefit from it. (Recall how last year's August sell-off was also triggered by the renminbi devaluation news.)

Collectively, these events triggered and increase demand in liquidity, creating further selling pressure. Market breakers kicked in on January 4th and 7th after a 7 % drop within the first half-hour of trading, with a lot of remaining sell interest. Then the "visible hand" took over. While Adam Smith, the Scottish political economist and the world's first free-market capitalist, would not be proud, it has worked so far!

Some seat-of-the-pants regulation was put in place ala Henry Paulson, as was done in the United States during the financial crisis. Newly-implemented circuit breakers were repelled, the selling ban of major shareholders was extended, and some institutions even bought more shares to support the market.

China also continued to close the loopholes for capital flight out of the country. On January 12th, China intervened in the offshore renminbi market that spiked overnight borrowing rates to 67%, sending a clear signal to speculators that the renminbi depreciation will be done on its own terms, not forced by the speculators.

Although it seems like the recent measures will slow the capital flight drain, the key will be how much of their reserves China will have to spend to support these policies in order to avoid another leg of rapid depreciation. But, until the end of the Chinese New Year in mid-February, it seems that China is committed to defending the level of renminbi at 6.60.

However, the demand for liquidity and the market stress is showing up in several other areas such as the Hong Kong Dollar Hibor Fixings (Inter-bank rate) that has also been increasing rapidly. These short-term oriented variables are good examples of liquidity demand anticipating long-term fundamental problems.

Our researchers on the ground are reporting that China is guiding its people to an 'L'-shaped recovery as reported on "Peoples' Daily News." While this is more realistic, it is also different from before because they never wanted to undermine their economic future. China recognizes that the high growth is not sustainable and will likely move away from numerical targets such as 7%. However, you can expect officials to defend the A-share market in the short-term due to the amount of leverage tied to the 2800 level (currently 3000) which will destabilize the market in the short-run.

However, they will likely defend the large SOEs' (State Owned Enterprises) stock prices if there were another sell-off episode, rather than defending the whole market. These should be stabilizing to the market for the next month but we believe that officials will use any stability to slightly depreciate the currency (2-3%) which will invite more instability to the markets. After all, the market should recognize that China is no different than any other country: they can only delay the inevitable; an economy full of excesses and slowing growth needs to adjust.

Potential Sources of More Volatility in 2016

Perhaps the big question is: why did the rest of the world react so heavily to this liquidity demand within China? After all, China is a closed economy, right? First, China is the world's second largest economy. The old adage, "the United States sneezes and the world catches a cold," now applies to China: "China sneezes and the world catches a cold." A depreciation of the renminbi is a significant risk to other Asian exporters.

As China tries to maintain the competitiveness of its exports, other emerging economies will likely get hurt since their currency depreciation gave them a relative competitive advantage because the renminbi is currently pegged against the U.S. dollar. A cheaper renminbi may also mean that China will start to export deflation to the rest of the world as its products become cheaper.

In the 1990s, this would have been classified as good news for the United States and the rest of the world because inflation was kept at bay and the U.S. consumer leveraged and spent in a benign environment. The "Goldilocks economy" as we called it; China produced and the United States consumed. Indeed, it was a good decade for stock prices if we ignore the ending and the Asian crisis in the middle!

Today, the situation is different. The threat is deflation, not inflation. Tremendous amounts of quantitative easing have been put in place to fight deflation over the last eight years around the globe, and we're still concerned about deflationary pressures. The big assumption for economic recovery and increased growth, and also one behind the U.S. Federal Reserve's (Fed) rate hike, is that the now smarter U.S. consumer will spend. The Fed saw that the labor market was tightening and wages were starting to increase.

In the 1990s, and in other periods, this created a multiplier effect for growth where consumers would spend more than the increase in wages. However, this has not been the behavior we are observing from today's U.S. consumer. Rather, since the Global Economic Crisis, consumers have been saving and paying-off debt. And, if this is indeed the behavior of the new, smarter U.S. consumer, all of the currency depreciation around the world competing for the U.S. consumer, will likely disappoint.

Accordingly, the result could be further deflation. This will be a key topic in investors' minds throughout 2016 as they reconcile if the Fed is right in assessing the new U.S. consumer's behavior for growth, or if former Fed Chairman Ben Bernanke, a deflationary expert, will be called back for more advice.

Another potential source of volatility in 2016 is downward revisions in earnings growth expectations. Currently, aggregate earnings for S&P 500 companies are expected to grow by 11% throughout 2016. Consistent with these growth expectations, the S&P 500 Index should be up by about 11% for the year barring an earnings recession. Will these earnings growth expectations become negative and, if so, where would the earnings cuts be coming from?

First, the behavioral tendency of sell-side analysts providing these estimates is to start the year with high expectations and downgrade these estimates into the summer months. This implies that growth expectations are a bit high for the year already. In addition, the energy sector should see another leg of downgrades if the oil price stays below $50 in 2016. Currently around $30, and falling below $30 for a period last week, according to Bloomberg, market consensus is that the average oil price will be around $50 in 2016.

We'd expect a minimum of a 30% earnings downgrade in the energy sector if oil stays below $50 most of the year. Second, the industrials sector may also see continued earnings cuts as machinery orders have been slowing down due to a strong U.S. dollar and a decline in investment in the energy sector. While just speculation at this point, consumer earnings could also be at risk, and must be watched carefully. Finally, financial earnings would be at risk.

2016 earnings expectations embed an assumption that the Fed will raise interest rates, and the yield curve will have a parallel shift (i.e., short-term rates will rise by the same amount as long-term rates). This assumption is usually positive for banks as they are expected to lend more at higher rates, resulting in higher earnings. However, this did not happen after the Fed's first rate hike last December.

Instead, the yield curve has flattened, meaning short-term rates went up, while long-term rates went down. Not built into assumptions yet, the flattening of the yield curve will likely result in cuts to earnings. In addition, banks signaled in October that they are tightening lending standards, limiting loan growth, and increasing reserves to cover for potential future losses, all of which are negative to earnings.

Finally, profit margins have been declining for the average stock in the United States since mid-2014. The continuation of this trend, driven by the lack of sales growth and potential increase in labor costs, could further cut the earnings growth expectations near zero which would take away the potential upside in equities.

Overall, there are enough concerns to keep volatility in the financial markets throughout 2016. It is important to navigate these times of high volatility to benefit from the upside potential that would follow. Stock selection and differentiation is key. We will be watching earnings, emerging markets currencies/capital flows, and the U.S. consumer to give us clues for the next leg up.