US Earnings Outweigh China Worries
Although there are many reasons that might justify a corrective pullback in global equity markets, concerns over the Chinese economic outlook seems among the more flimsy. To my mind the Chinese economy is still enjoying an orderly economic slowdown and global market reactions to developments in Chinese financial markets are a gross over reaction.
As regards to China’s share market, what goes up too far too fast usually must suffer a cleansing pullback. Anyone who’s looked at China’s mainland share market over the past decade or so much be aware that 1) it is highly volatile and largely driven by the whims of less sophisticated mum and dad investors and 2) its performance bears little relationship to that of the economy.
What we’ve had is a mini-bubble in Chinese shares through last year which is now in the throes of a correction. As in the United States, the Chinese authorities thought the imposition of “circuit breakers” might reduce the risk of untoward equity market volatility. But at least in China’s case, these circuit breakers have arguably only added to fear and uncertainty, in part because the levels of intra-day share prices declines permitted before the market was temporarily closed were set too narrowly given the underlying volatility in the market.
For foreign investors, the shenanigans that followed with Chinese stock prices was messy and discomforting, especially given Chinese policy makers had up until recently developed a good reputation for being able to manage their economy.
But again, we should not forget the performance of Chinese shares usually bears little relationship to the performance of the economy and the overheated market needs to correct no matter what the authorities do. For what it’s worth, Chinese policy makers – for now at least –have given up trying to limit intra-day share price volatility by abandoning their circuit breakers. Chinese shares, meanwhile, seem to be finding their own feet. It does not mean prices won’t fall further – they probably will – but it at least won’t be associated with ham fisted meddling by bureaucrats.
China’s moves to devalue the Yuan against the US dollar has led to further confusion. Again the damage to global investor sentiment has not been helped by less than transparent communication from Chinese regulators as to what they are up to.
China maintains a managed peg for the Yuan to the US dollar. The Yuan is allowed to trade within a permissible daily band against the US dollar, and market forces that would otherwise push the Yuan beyond these bands is – in theory at least – met by official intervention to keep Yuan movements contained. In deciding what US dollar level to target, China made an important decision late last year to manage the Yuan with reference to a “Yuan index” against 13 currencies, including the Euro, Japanese Yen and even the Australian dollar.
Even without this Yuan index, the effect of China’s exchange rate system is that broad based gains in the US dollar across global currency markets would imply strength in the Chinese exchange rate against cross-currencies if it maintained its peg to the US dollar. To limit such appreciation when the US dollar is rising, the Chinese have recently decided to devalue against the US dollar – which is effectively mirroring the policy of revaluation in earlier years when the US dollar was falling.
Some analysts have interpreted this as China seeking to devalue their currency as a desperate attempt to sustain economic growth in an otherwise weak economy. But it’s really all about maintaining some semblance of overall exchange rate control and stability when the world’s leading currency is trending up. Indeed, China claims it will seek to keep the overall Yuan index reasonably stable this year, which if so would argue against the idea it’s about to embark on a process of competitive devaluation.
Indeed, given strength in the US dollar, market pressures of late have been such that the Yuan would have fallen a lot further against the greenback were if not for official intervention to hold it up – through the sale of foreign exchange reserves for the local currency. So China has in fact being trying to hold the Yuan up, rather than pushing it down!
All that aside, there is cause for investors to be nervous over the short-to-medium global equity market outlook. For starters, history shows that Wall Street usually suffers at least several months of weak performance when the Federal Reserve embarks on a tightening cycle – and the latest cycle seems to be no exception. What’s more, US share prices have run ahead of earnings in recent months, leaving price to earnings valuations somewhat stretched and in need of a cleansing correction in any case.
More ominously, it’s been apparent for several months that the breadth of US share prices gains has been narrowing to become highly depending on a handful of high tech darlings such as FaceBook, Amazon, Netflix and Google.
With US profit margins still at record highs, to my mind the biggest risk for the 7-year global bull market is a levelling out and eventual decline in US corporate earnings performance. Unlike the wobbles in the Chinese share market, a decline in US corporate earnings is highly correlated to multi-year bull and bear runs for US stocks – and global equities more broadly.
David is one of Australia's leading economic and financial market analysts. His is Chief Economist with BetaShares, and an Economic Advisor to the National Institute for Economic and Industry Research (NIEIR). His has held former roles as senior commentator with The Australian Financial Review, Macquarie Bank interest rate strategist and Federal Treasury economist. He is also author of the online e-book, TheAustralian ETF Guide.