Global Investment Strategy
February 1, 2016 (Weekly Update)
Paul Christopher, CFA® Head Global Market Strategist
Weekly insights from the Global Investment Strategy team
- Falling oil prices and disappointing news out of China repeatedly have cycled through global markets and created pessimism.
- While we see risks from these two sources, the negative sentiment seems exaggerated.
What it may mean for investors
- We think the current market pessimism offers potential opportunities for investors with a disciplined approach to meeting their financial objectives.
How Oil Prices, China, and Equity Markets Intersect and What to Do About It
Since the beginning of the year, global markets have been riding a roller coaster. Unfortunately, when pessimism is unusually strong, some worries seem to come around again and again—like a merry-go-round. China’s problems and tumbling oil prices repeatedly have seized the headlines this month and weighed heavily on the equity markets. Clearly these factors present risks, but we think revolving concerns have been exaggerated and may obscure the long-term vision that investors need to stick with their investment plans. Here, we consider the intersection of these three dynamic market forces and briefly review risks and opportunities for each, until this wild ride ends.
What are the risks?
Oil prices and equity markets: Oil prices have not moved closely with equity prices historically, but the recent drop in oil prices poses two related risks for equities. First, the imbalance in the oil market comes from an oversupply. The process of rebalancing global oil markets may fall heavily on U.S. energy producers, triggering layoffs and spending cuts to the detriment of an already-weak U.S. manufacturing sector. Second, the latest slide in commodity prices pushes near-term inflation expectations closer to zero and towards deflation risk. If prices in the economy fall (deflation), consumers may be tempted to delay their large purchases until prices stop falling. Of course, this behavior damages revenues, hiring, and confidence throughout the economy.
Although crude oil prices could slide further, we think a bottom is close. Global supply and demand rebalancing are underway, and today’s low prices may accelerate the adjustment. We believe oil prices appear to be forming a bottom, and with it, the correlation with equity prices should return to a more historically (lower) average.1
China: China is in a government-managed transition from a manufacturing economy to a services economy. We see risks in China but not a crisis. For example, countries historically have devalued their currencies during periods of extreme economic stress, but China’s economy seems stable to us (more on that below). Moreover, devaluation is part of the government’s stated long-term strategy to open China’s financial markets to global trade. Chart 1 illustrates that China’s currency is weakening against the U.S. dollar, not against a broad basket of currencies. Put differently, the yuan is depreciating to realign with the dollar; it is not weakening against a broad group of currencies.
Chart 1. China’s Currency Depreciation Has Been Narrow – and Mainly Against the U.S. Dollar
Sources: Bloomberg and Wells Fargo Investment Institute, 1/27/16 The J.P Morgan nominal broad effective exchange rate for the yuan is a trade-weighted average of the yuan’s exchange rate against the U.S. dollar, the euro, the British pound, the Japanese yen, the Mexican peso, and smaller weights to other European, Asian, and Latin American trading partners of China.
Another source of market concern is China’s corporate debt level. Government-owned companies assumed most of the debt in the post-2008 government stimulus program, but private Chinese companies collectively lowered their debt as a percentage of their total assets, according to a study by the Hong Kong Institute for Monetary Research.2 Despite the build in debt, bond yields do not suggest a crisis, in part because China (and other Asian economies) has a high savings rate. Chart 2 shows that the yields across a variety of Chinese corporate bond maturities have declined since the second half of 2015, despite a nearly 50-percent decline in China’s equity market, as reflected by the performance of the Shanghai Stock Exchange Composite Index.
Chart 2. Chinese Corporate Bond Yields Have Declined During Recent Financial Disruption
(Yield-to-Maturity at Various Maturities and at Selected Dates, in Percent)
Source: Chinabond via Bloomberg, and Wells Fargo Investment Institute, 1/27/16. Notes: The yields shown are for local-currency corporate bonds rated AA- and that are traded on the China Interbank Exchange. The yield values shown on the curves are contributed by China Government Securities Depository Trust & Clearing Co Ltd. Past performance is no guarantee of future results.
As China moves through its economic transition, debt and unemployment remain the main risks to watch, but we see no reason for alarm. The government will have to facilitate the write-off of large loans at construction and processing firms that will be closed in the transition. Some of those bankruptcies could disrupt certain bank operations and create unemployment. If China mismanages the tasks of retiring the bad debt and finding new jobs for the displaced workers, the economy could suffer a significant disruption. Such a disruption is the “hard landing” scenario that some investors worry about.
Still, it is very important to remember that the largest part of China’s economy is healthy and growing. The service sector is now the principal source of Chinese economic and job growth, and wages are rising. Households appear to be taking advantage of these developments. Now, many market watchers (ourselves included) treat Chinese government statistics with caution, but we see a broad array of evidence that China’s consumer and service industries are financially healthy, and that the overall economy appears stable. Table 1 provides a sample.
How much longer will the risk aversion continue?
Worries about oil prices and China may linger for a matter of days or weeks, but sentiment should improve—while the U.S., European, and Japanese economies continue showing solid (albeit slow) growth, and while China’s economy slows but remains stable. Here are the factors we are watching:
- Supply-demand adjustments in oil markets: Once supply cuts accelerate (possibly by spring), oil prices should stabilize and defuse deflation fears. Some additional years may be needed to weed out additional producers and prompt a new oil price rally.
- China’s policies regarding its currency exchange rate: Chinese officials are aiming for the yuan to depreciate but this month confused currency traders by abruptly changing the yuan’s depreciation pace. Sentiment should improve if the yuan maintains a steady depreciation.
- The U.S. dollar: The dollar has been strengthening globally, but the yuan may face less depreciation pressure, if the dollar pauses or consolidates. The dollar may consolidate if Federal Reserve officials signal no new rate hike this spring.
Keep perspective, take action
Times like these can be upsetting for investors. This is why we strongly recommend identifying your financial goals, investment time frame, and risk appetite. Your investment professional can help you build a portfolio that looks past today’s emotional selling and sets a long-term strategy to align our expected returns and your long-term goals. From that strategic perspective, we see potential opportunities for a focused investment plan to buy selectively those markets that have sold off in recent months. In particular, investors should consider that equity market valuations are attractive at approximately 15 times the 2016 consensus estimate. Even in the balance of the year, our historical market research indicates that the six-month period following an equity-market correction often can reward patient investors. In addition, more than half of the S&P 500 Index constituent companies currently pay dividends that exceed the current 10-year U.S. Treasury note yield.
1 For more details on why we think oil prices are near a bottom, please see our Global Investment Strategy, “Why we are no longer a super-commodity bear”, January 19, 2016. For a discussion of the historically low correlation between the oil and U.S. equity markets, please see our Global Investment Strategy, “The investment upside to sinking oil prices”, January 28, 2016.
2 For more information, please see “Corporate Leverage in China: Why Has It Increased Fast in Recent Years and Where do the Risks Lie?”, Hong Kong Institute for Monetary Research, April 2015. www.hkimr.org/uploads/publication/416/wp-no-10_2015-final-.pdf
Paul Christopher is the head of international strategy and the co-head of real asset strategy for Wells Fargo Investment Institute (WFII), an organization that provides global manager research and investment strategy advice to Wells Fargo’s Wealth, Brokerage, and Retirement (WBR) division. WBR is comprised of Wells Fargo Private Bank, Wells Fargo Advisors, Wells Fargo Institutional Retirement, and Abbot Downing businesses, accounting for more than $1.6 trillion* in assets under administration.
Mr. Christopher focuses on the international economic outlook and offers investment advice on currencies and commodities. He is frequently quoted in the national media, including The Wall Street Journal, The New York Times, Forbes, Time, Investor's Business Daily, USA Today, Bloomberg News, ABC News, NBC News, and CNBC.
Prior to joining Wells Fargo, he developed economic strategies to trade in global financial and commodity futures markets for Eclipse Capital Management. In previous positions, Mr. Christopher supplied international economic perspectives for Wells Fargo predecessor A.G. Edwards, and advised institutional clients of Istanbul-based Global Securities on the oil-based economies of the Caucasus and Central Asia. He has consulted with the governments of Hong Kong, Egypt, Russia, Kazakhstan, and the Kyrgyz Republic on monetary policy issues.
*As of Sept. 30, 2014
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