China’s woes are the biggest threat to the global economy, according to Standard Life Investments’ Jeremy Lawson, who warns that while not his central thesis, the fallout from a hard landing could have huge repercussions for investors.
Growth in China has been slowing for a number of years and this trend has been well-flagged by industry experts as a potential headwind for investors to consider (along with its booming property market and murky shadow banking system) as the country’s authorities attempt to shift its economy from an investment-led model to a consumption-driven one.
Nevertheless, up until recently, Chinese equities had been on a meteoric rise thanks to stimulus from the country’s central bank and as a result of the recent Shanghai-Hong Kong Stock Connect programme.
However, investors will now be aware that a sharp pull back from retail investors (who about account for 85 per cent of participants in mainland markets) has meant Chinese equities have been in freefall over recent weeks with the Shanghai Exchange Composite Index losing close to 30 per cent over the past month, according to FE Analytics.
Performance of indices in 2015
Source: FE Analytics
The Chinese authorities have implemented a series of measures to limit the recent rout including suspending new share offerings, ordering brokerages to buy shares and promising to provide liquidity, while around 1,400 firms – half of China's main shares – have halted trading.
However Lawson, who is the group’s chief economist, says investors need to be aware of the possible ramifications of the increasingly negative situation in the world’s second largest economy.
“With Europe finally recovering after years of sub-par growth, the biggest threat to the global economy is arguably China,” Lawson said.
“Real GDP growth moderated to an annualised rate of just 5.8 per cent in the first quarter, which dragged year-on-year growth down to 7 per cent. Both were the weakest outcomes since the global financial crisis.”
“While real growth has slowed significantly in recent years, the deterioration in nominal activity has been even more dramatic. As late as the middle of 2011, nominal GDP was growing at an annual rate of 19 per cent; in the most recent quarter nominal growth was just 5.2 per cent, with growth in the GDP deflator slipping into negative territory.”
“This economy-wide disinflation, and more recently deflation, has mostly been due to rapidly declining commodity prices, though non-commodity consumer price inflation has also slowed.”
Lawson says the heart of the problem in China has been the country’s overheating industrial and real estate sectors and while it isn’t his central thesis, he warns that if there is a financial crisis, the knock-on effects could be very harmful.
“Although it is not our baseline expectation, a hard landing in China would obviously be a large negative shock for the global economy, representing as it does 12 per cent of global GDP at market exchange rates and some 18 per cent of global manufacturing exports.”
He added: “It has also been the dominant source of demand for global metal commodities and, according to the IMF, it has accounted for more than a third of global growth over the past seven years.”
However, on a more positive note, he says emerging economies are in a much better position than they were in the late 90s when the developing world was hit by a financial crisis – which raised fears of a worldwide economic meltdown due to financial contagion.
Performance of sector during Asian financial crisis
Source: FE Analytics
“There is good news. Our research shows that most emerging markets are in a much better position to withstand external shocks than they were in the 1990s, thanks to improved fiscal and monetary policy frameworks. One example is much greater willingness by most countries to allow their currencies to depreciate in the face of external shocks.”
Nevertheless, the recent falls in the Chinese market and the concerns surrounding the future of the country’s economy are very close to FE Alpha Manager Crispin Odey’s doomsday prediction at the start of the year.
In January, the star hedge fund manager warned that a downturn which will be remembered for 100 years is on the cards as, despite central bankers’ best efforts, economic growth has been very anaemic.
He therefore warned that if there were any economic headwinds (which would probably originate from emerging markets) the equity market would be “devastated” – even more so than it was in 2008.
Performance of indices in 2008
Source: FE Analytics
“My point is that we used all our monetary firepower to avoid the first downturn in 2007-09, so we are really at a dangerous point to try to counter the effects of a slowing China, falling commodities and emerging market incomes, and the ultimate ‘first world’ effects,” Odey said.
“This is the heart of the message. If economic activity far from picks up, but falters, then there will be a painful round of debt default. We are in the first stage of this downturn. It is too early to see what will happen – a change of this magnitude means the darkness and mist is very great.”
DeVere Group’s Nigel Green is also concerned about the Chinese economy and the potential ramifications. He says the fact that the Chinese authorities have stepped in to try and stop the rot in the country’s equity market is a worrying sign.
“The measures taken this week in China by the government to bring the sell-off to a stop should be of real concern to investors. This is because the frenzied implementation of a barrage of measures hints that the Chinese government is perhaps concerned about the wider economic problems facing the country,” Green said.
“For global investors, the stock market crash, and the attempts to halt it, bring into sharp focus again that the Chinese economy is slowing rapidly.”
“You may no longer be able to see it in the share prices so clearly, thanks to the measures, but you are likely to increasingly see it production and consumption – and this will have an enormous impact on the global economy. This will not be lost on investors.”
“If a financial and banking crisis follows from this – as banks and brokerages fail to reclaim the loans made to investors – there will be a knock-on effect on the Chinese and global economy. Trade needs banks and finance to support it. Falling global trade is associated, historically, with bearish periods on financial markets.”
However, Robert Davis, manager of the NN Emerging Markets High Dividend Strategy fund, says investors shouldn’t fall into the trap of being too bearish on China.
He says that while the market was in bubble territory earlier in the year, the fact that the Chinese central bank has implemented measures to cool the market is a positive. He therefore adds that a buying opportunity has opened up.
“Healthy equity markets are an important component of the Chinese government’s broader plans to reduce debt in the economy. Strong markets allow IPOs and other forms of equity raising, effectively converting debt into equity,” Davis said.
“By encouraging retail investors to participate without monitoring leverage levels, the local markets rallied by more than 130 per cent in a few months fuelled by ballooning margin trading. When the authorities woke up to the issue and tried to reign in leverage, it pricked the bubble it had created.”
He added: “It’s noteworthy that the rise and fall in the Shanghai Composite index exactly mirrors the increase and then contraction of margin lending by Chinese brokerages.”
