August’s abrupt sell-off ensured the summer holidays were not quite as relaxing as many market participants had hoped. Much has been written about the causes and influences of the extreme volatility but it is clear fundamentals played a significant role.
Developed world stockmarkets suddenly appeared to acknowledge something other asset classes have been concerned about for some time – that the fundamental health of the Chinese economy is nowhere near as robust as had hitherto been implied by valuations.
That the Chinese economy is slowing should not have come as a surprise. Recent quarterly growth figures have lacked credibility compared with other real economic data. Even Chinese Premier Li Keqiang allegedly mistrusts the country’s official economic statistics, preferring to track growth by looking at real data. The Li Keqiang index, as it has become known, tracks growth in outstanding bank loans, electricity production and rail freight volumes, and currently shows a reading of just 2.5 per cent year-on-year. It last visited that level in November 2008, just after Lehman collapsed.
Of course, as a long-term fund manager, I am more concerned by the long-term outlook for the Chinese economy, and what that means for the global economy as a whole, than I am about its current predicament.
I have been consistently cautious in this respect for several years and I see no reason to change this view yet. Indeed, the number of reasons to be cautious about China is increasing.
The transition from an economy relying heavily on fixed asset investment to one which more closely resembles the Western, consumption-based economic model has been achieved before by other developing economies.
It is a very long road, however, and one with many bumps in it. In the case of China, the transformation also requires a different political approach but recent interventions in the stock and currency markets suggest the authorities are struggling to let go of the controls.
Meanwhile, the level of private sector debt in the Chinese economy is increasingly attracting attention. As the chart (left) demonstrates, Chinese private debt already surpasses the peak reached in the US in 2008 and is fast approaching the level of the UK’s debt burden reached just before the financial crisis. This is alarming and suggests the Chinese economy will have to go through a period of prolonged debt moderation too at some stage, with negative implications for Chinese growth and in particular for its banking system.
The risks facing the Chinese economy are substantial and the market was right to start to worry more about them, albeit belatedly.
However, although the market correction implies the risks are now discounted more appropriately, it does not mean they have gone away. Far from it.
In 2009, China rode to the rescue of the global economy with a massive fiscal stimulus package. It does not have the balance sheet to repeat this trick now. Unlike other major economies, however, Chinese interest rates are not yet at the zero-bound so it does have scope to loosen monetary policy and has already started to do so.
This in turn creates problems for the rest of the global economy. Instead of facing internal deflation, China could export deflation to the rest of the world. The deteriorating fundamentals of the Chinese economy therefore have signification ramifications for the global economic outlook.
Recent events have not necessitated any changes to my portfolio strategy but they do provide further vindication to the cautious view of the global economy I have held for some time.
I have built the portfolios on the expectation they will receive little help from macroeconomic trends.
Nevertheless, there are some parts of the market that could continue to be very negatively impacted by China’s ongoing woes.
Commodity prices and commodity-related stocks, for example, have already fallen a long way but are still far from low by historical standards. I continue to prefer companies that are more in control of their destiny.
Neil Woodford is head of investment at Woodford Investment Management