25th August 2015
Didier Saint-Georges, managing director and member of the Investment Committee at Carmignac, looks at the ongoing market turbulence in China and what it means for global investors…
Interpreting the violence of market movements
The movements which started in commodities and emerging markets started to impact developed equity markets, which when they broke out from trading ranges, triggered outflows from passive money (notably momentum ETFs). This, compounded with summer trading liquidity conditions and scare stories about China started a chain reaction.
On currencies, the weakness of the Euro, notably in the past year, turned it into a funding currency for considerable amounts of carry-trade in favor of EM assets. The unwinding of these carry-trades, together with the questioning on the Fed’s next monetary policy decision, explains the strength of the Euro.
What is going on in China?
The RMB devaluation was poorly communicated, but should not be understood as a last-ditch effort by China to support its economy. While a strong currency never helps in a weak economic backdrop, a 3% fall in the RMB is not going to change the Chinese macro picture. It should be noted that, as opposed to Japan and pretty much the rest of the developed world which started by monetary easing before reforms, China started with reforms several years back and started monetary easing only recently. It therefore took the risk of a serious slowdown, but still has ammunition to use if necessary in support of its economy.
We have been arguing for a long time that the Chinese economy is weak, which is why we hold no banks or cyclicals in this country. How weak is very difficult to quantify, official numbers being notoriously unreliable. The Services part, which is today more than half of China’s GDP, is growing in the region of 10% p.a , which makes us “guesstimate” that overall China’s growth is probably growing at a pace in the region of 5%, as there is no question that the industrial part is very weak (hence the fragility of other EMs such as Brazil).
One of the key issues is the loss of trust in the Chinese authorities. Not only their transparency is very poor, but also their management of the domestic equity market bubble has been pitiful, so has been the management of its bursting, and later their decision and communication on the RMB. This loss of trust should not be underestimated. It is critical to capital flows.
What are the market risks?
At this stage, we are talking about an economic slowdown, not a meltdown. But the markets are vulnerable because of the conjunction of two key weaknesses:
Firstly, the bull market has been driven mostly by a rerating thanks to zero-interest rate policies and QE. Valuations suggest that this rerating is over, therefore earnings growth needs to take over, which is unlikely in our opinion (you know that our core view about a very weak global post-crisis recovery)
Secondly, in case of further economic disappointment, should China really weaken further, Governments’ and Central banks’ tool boxes have been pretty much exhausted: Government have no budget flexibility, rates are at zero, and QE is maxed-out.
The bear case would be that, not only investors lose trust in China, but would also lose faith in the fact that Central banks either to have the capacity to support asset valuations AND/OR economic growth.
It is certainly possible that, if push comes to shove, Central Banks could indeed find additional ammunition (why not a QE 4 in the US instead of an interest rate rise if that’s what is really needed? In the final analysis debt sustainability needs inflation).
But this would be a massive U-turn from recent stance, which can hardly be expected in the very short term, hence an immediate danger zone. Loss of confidence + fragility could make markets overshoot to the downside. Hence our very cautious hedging policy put in place over the past few days (details in recent Flash Notes and Reporting).
Investment strategy going forward
Based on the above, the immediate priority is risk management. If and when markets find a base and we enter a stabilised period, then at best VERY scarce growth will be the long term horizon for investors (we don’t see how investments or consumption could materially accelerate until global deleveraging has made serious progress). Benchmarked funds or ETFs will be faced with very low equity index returns. Only active management, notably via alpha generation, will be able to produce decent absolute returns.