It’s been a fairly horrendous start to the year for investors as China’s woes, as well as increased geo-political tensions, have caused global stocks to drop sharply in value.
According to FE Analytics, all major equity indices are in negative territory year-to-date and, apart from the S&P 500, all have lost more than 5 per cent already.
Performance of indices in 2016
Source: FE Analytics
Given it has been such as a poor start to 2016 (following a 2015 which was crammed full of volatility and significant falls) investors are understandably becoming more cautious on equity markets, especially given it has been nearly seven years since they bottomed after the global financial crisis. 
Certainly, there have been a number of professional investors who have been looking to de-risk their portfolios as FE Trustnet highlighted in a recent article.
“Slowing global growth (with China at its epicentre), disinflationary pressures but continued high levels of government and consumer debt constraining consumption growth, combine to make for a cocktail of concerns in the outlook for 2016 which is why in the near term we think investors need to take tread with caution and be very selective on where they invest,” Tilney Bestinvest’s Jason Hollands said.
He added: “Just “being in the market” won’t be good enough.”
However, while some investors may wish to liquidate their holdings and sit it out in cash as a result of the ramped-up volatility, Edward Smith – asset allocation strategist at Rathbones – says there are five principle reasons as to why he thinks investors should keep the faith.
This is not an economic correction
First and foremost, Smith says investors need to realise that the recent volatility has nothing to do with a change in the economic outlook.
Therefore, the strategist says investors shouldn’t fear a financial meltdown like in 2008.
“This has been a financial correction, not an economic one: the probability of a recession in developed markets in the next four months currently implied by the macroeconomic data is very low,” Smith (pictured) said.
“An economic crash – in the West or China – appears unlikely. We expected markets to become volatile as the US started to raise rates. And they have, but we reiterate that policy tightening is not a problem while a healthy gap between growth and interest rates (or the return on capital and the cost of capital) remains.”
In fact, the economic outlook is improving
While investors are seemingly obsessed with data out of China, Smith says they are missing more positive news elsewhere in the world.
In particular, he says the likes of Europe and Japan – two regions which are being heavily supported by very accommodative central bank policies such as quantitative easing – are improving from an economic perspective.
“Economic data continue to surprise to the upside in Europe and Japan,” he said.
“Across the Western hemisphere non-manufacturing PMIs are firmly in positive territory. Six of eight developed market services PMIs are above 55, up from three last quarter. This is far from an Armageddon scenario.”
“Disappointing US manufacturing ISM data should be taken in context: the sector accounts for just 15 per cent of GDP; services is the main driver of Western economies and in the US that ISM is at a healthy 55.3.”
Chinese equity market weakness has little bearing on economic data
Of course, the major reason behind the increased nervousness towards equities is China and its own significant market falls.
FE data shows that not only is the Shanghai Stock Exchange Composite down 14 per cent already this year, but is has now lost more than 40 per cent since June 2015 (though before that it had risen close to 180 per cent over the 12 previous months).
Performance of indices since June 2015
Source: FE Analytics
However, Smith says investors need to calm themselves about thesr eye-watering falls.
“Recently, markets have become obsessed with Chinese data and stock market performance. We think this focus is misguided. China’s equity market is notoriously fickle, driven as it is by retail investors,” he said.
“Granted, China’s leaders bungled attempts to support the stock market; the now-abandoned ‘circuit-breakers’ are arguably making the falls worse, and have stoked fear in investors. Still, only a small proportion of households dabble in the stock market, which should prevent any market crash from contaminating the real economy.”
“There is no correlation between consumption spending and stock market returns, financial interlinkages are small and companies are not reliant on equity market capital to the same degree as Western counterparts.”
China’s slowing growth is not new news
Though concerns about China are starting to appear in the mainstream media, Smith says investors should realise this is not a new development.
He says this is all part of the well-communicated plan from the Chinese authorities to shift the country’s economic model from investment led growth to the power of consumerism.
“China is moving from an economy led by manufacturing and construction to one being driven by services and private enterprises. These segments of the economy make up more than half of China’s output and continue to grow strongly,” he said.
“The old, heavily industrial China is in a severe slump, one that is likely to get worse before it gets better as policymakers accelerate restructuring in 2016. Remember, the overall rate of growth in the economy has already halved over the last five years and the world has not fallen apart.”
“The January trade data release shows the volume of Chinese exports increased in December, helped by the currency devaluation since August. Importantly, there were also signs of improving domestic demand: import volumes grew by approximately 7 per cent in 2015. [This is] further evidence that the turmoil of the markets in no way reflects the economic trends.”
Currency devaluation is a necessary step
Apart from poor PMIs and slowing growth levels, the major reason why investors have become frightened by China is due to the authorities’ wish to devalue the currency.
Relative performance of currencies over 1yr
Source: FE Analytics
However, Smith says this isn’t something investors need to be overly concerned about as the currency has been too strong of late.
“The falling renminbi frightened investors further, but, again, this is about poor communication by the People’s Bank of China (the central bank) rather than an indication of panic.”
“In December it said it was moving toward abandoning ties to the dollar in favour of a trade-weighted float. It seems that they are implementing that plan much quicker than first indicated. This month, the central bank’s chief economist confirmed this was the case.”
“If the policy change had been set out more plainly in advance, the market would probably have been much more sanguine – it’s eminently sensible, after all.”
“This is far more another dollar appreciation story than a renminbi depreciation story. The Chinese central bank is spending foreign exchange reserves in record amounts to stop its currency from falling too quickly against the dollar, not engage in ‘competitive devaluation’. Progress towards a free floating renminbi is part of making China a market-based economy.”
