First Western Investment Research
August 24, 2015
China is the world’s second largest economy and one that we have pointed to often as being significant to the global growth picture. It’s not new news that China’s economy is decelerating. We’ve been talking about their slowing manufacturing data for many months. Over the past two months, with China’s bear market in stocks and recent currency devaluation, we’ve seen the debate over a soft versus hard economic landing heat up. We have been in the camp that their government would use a combination of broad Central Bank action and very focused policies to engineer a soft landing, and gradually bring their economy’s growth rate down toward a more sustainable 5% from its current 7%ish rate. There’s a pervasive fear in the market, currently, that the landing may be hard and impact global growth.
The Chinese government has certainly shown that they’re not infallible with the stock market fiasco of the past year. They encouraged a roaring bull market through their policies only to have it crash in June. Their inability to control the selloff shows that regardless of their “many levers”, the Chinese government is not omnipotent. That creates a nervousness surrounding China’s recent currency moves. What we have seen, to date, in devaluation of the yuan (renminbi) is not enough to create a global currency crisis. But investors are uncertain what additional steps China’s government might force their central bank to take to encourage stronger exports. This is at least the second time this year that concerns over China and slowing global growth have been the catalyst for a selloff/correction (remember January).
In the face of uncertainty and extreme volatility, Fed Chair, Janet Yellen has not come out and soothed the markets by telling us that the Fed will hold off on rate hikes until the global picture is clearer. Higher rates would likely drive the dollar higher, hurting revenues and earnings for U.S. based companies doing business overseas. The Fed has been very pleased with employment progress at a time when they want to be able to start the rate normalization process. It is not the normal course of business for the Fed to focus on the international front rather than our domestic economy, but admittedly, we’re in a more global environment. The Fed will have their annual Jackson Hole retreat late this week which Yellen plans to skip so it’s unclear when we’ll have comments from the Fed and what tone they’ll take. The markets hate an information vacuum so the lack of Fed news adds to volatility.
The drop that we’re seeing in stocks, though violent, is normal. We’ve experienced corrections greater than 10%, historically, on an annual basis. But we’ve had such a smooth ride for so long with no correction in over four years that it’s difficult to remember what one feels like. Valuations have been a bit above average, so vulnerable to the fears of slowing global growth that have surfaced. However, valuations are certainly not dramatic which should help control the downside. All year, we’ve written about expecting increased volatility and a sell-off as we move into the Fed’s initial rate hike. Regardless, once you’re in the midst of the selling, it feels lousy.
This downward move may last longer than a week or two and may certainly have more downside to it. But we do not see this as the beginning of a bear market. Bear markets tend to be born out of recession and credit crises, neither of which we see currently. We believe we’re experiencing a more normal correction within a bull market, an event that’s nearly impossible to trade. Markets reward discipline which means we need to remain committed to our longer-term investment plans.
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