Investors should beware more pain stemming from the current turmoil in Chinese equity markets and widespread concerns about the health of the world’s second largest economy, according to star fund manager Neil Woodford.
Negative sentiment towards China has led to broad risk averseness for most of 2015, heightened since the panic selling on Black Monday six weeks ago.
Performance of indices since Black Monday
Source: FE Analytics
Woodford, who runs the £7bn open-ended CF Woodford Equity Income fund and the £824m closed-ended Woodford Patient Capital Trust, says there are plenty of reasons to expect more downside.
“The risks facing the Chinese economy are substantial and the market was right, in my opinion, to start to worry more about them, albeit belatedly,” he said.
“But although the market correction implies that the risks are now discounted more appropriately, it doesn’t mean they have gone away – far from it!”
“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.”
A key driver of the spike in anxiety over China from market participants comes from a belief that its economic growth was rapidly slowing, even more than the official statistics were suggesting.
“That the Chinese economy is slowing should not have come as a surprise – recent quarterly growth figures have lacked credibility when compared with other real economic data,” Woodford (pictured) added.
“Even the 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.”
CF Woodford Equity Income was, like the majority of funds in the IA UK Equity Income sector, hit on Black Monday but has escaped the worst of it.
Only 10 per cent of funds in the 84-strong sector have made a positive return since the sell-off and while Woodford’s 0.44 per cent is not as high as the likes of Gervais Williams’ CF Miton UK Multi Cap Income and Mark Slater’s MFM Slater Income, it is still well ahead of the sector average.
Performance of fund, sector and index since Black Monday
Source: FE Analytics
The manager says he put together his portfolio with a strong view that the macro economy was weak and going to get weaker.
“Recent events haven’t necessitated any changes to my portfolio strategy but they do provide further vindication to the cautious view of the global economy that I have held for some time. I have built the portfolios on the expectation that they will receive little help from macroeconomic trends,” he explained.
“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.”
Performance of index over 4yrs
Source: FE Analytics
“I continue to prefer companies that are more in control of their destiny. In turn, this allows continued confidence in what the portfolios can deliver in the long-term but it is important to remain very aware of the risks.”
Woodford says the planned transition of the Chinese economy from top-down communist model to a Western, consumption-based economic looks precarious.
“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.”
Chinese private debt is now at higher levels than in the US at the onset of the financial crisis in 2008 and close to UK levels at this time, Woodford says, spelling a disturbing trend in the face of slowing economic growth.
“This is alarming and suggests that 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,” he said.
“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 an 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.”