Oil, China, and some disappointing economic news in the U.S. combined to drive markets lower last week with most of the damage occurring in Friday’s session. Equity markets around the world fell between 2% and 3% on the week while China’s mainland stock market plummeted 8.65%. The DJIA is back in correction territory on similar grounds that pushed the market into correction territory last August (China, oil).
Regarding China, as we detailed in a recent flash memo, in no way should investors mistake the Shanghai stock market as an indicator of the Chinese economy. Mainland stock markets are dominated by retail investors, state owned enterprises, and represent a very small sample of the overall Chinese corporate economy. We do expect further currency adjustments and economic stimulus which the PBOC will most likely pursue if conditions warrant. Continued depreciation of the Yuan, which became nearly 40% overvalued with the accent of the USD, is likely but we do not see a major devaluation in the cards which could potentially elicit retaliatory devaluations across Asia. Furthermore, unlike the Fed, the PBOC, after four rate cuts and four cuts in reserve requirements, still has room to maneuver. China has very low levels of external debt, a strong current account surplus, and has recently shown some encouraging economic signs including increasing auto sales and strong money supply growth.
Along with China, oil and the high yield market are commonly cited as risk indicators concerning market participants. Oil is most likely much closer to its bottom and ultimately should be viewed through the lens of short term pain (reduced capital expenditures and energy market stress) in exchange for long term gain (reduced inflation and input costs globally). The reduced cash flow and corresponding reduction in capex will correct the supply imbalances eventually and should be able to offset the impact of Iranian oil coming online over the course of the next couple of years.
Overall, we do not see clear signs of recession in any major economies of the world outside of Brazil and Russia. Importantly, very rarely do bear markets materialize without a recession or some material global imbalance. Runaway inflation (70’s), commercial real estate S&L crisis (80’s), Kuwait invasion oil price spike (90’s), tech bubble (90’s), housing bubble (00’s) all triggered deeply negative global systematic forces. This leaves us in the buying ‘on the dip’ and trimming ‘on the rip’ camp looking forward.
