Avoid the lemming response

Share markets had a very poor August. The ASX200 finished the month down by 8.6%, at 5207, the lowest end-of-month close since January 2014. The US share market, as represented by the S&P500, fell by 6.3%. These were the worst months for the two markets since October 2008 and March 2012 respectively.

The end-of-month figures disguise, to some extent, the sharpness of the decline within the month. The US market dropped by 11% in just six trading days to 25 August. The Australian market weakened earlier (it is more exposed to commodities, of course), but fell by a hair-raising 7% in the three trading days to 24 August, when it closed at 5001.3. At this stage, the Australian market was down by more than 16% from its late-April peak. It has not closed below 5000 for more than two years.

Emerging markets have been pummelled even harder, with a broad global index (the MSCI) down by more than 27% from its peak. Unfortunately, I have neither the space nor the expertise to analyse emerging markets further.

The sharpness of the decline in markets both here and abroad has led many to speculate that we are in the throes of a new bear market.

It’s worth noting that, while the speed of the correction was something not seen since 2009, its magnitude was almost normal. There were broadly similar-sized corrections in the US in 2010, 2011 and 2012. Indeed, suppose one goes back to 1970 and calculates for each year the greatest fall during the year. Excluding the years where the economy was in, or on the way to, recession, the median fall in any calendar year is still more than 10%. OK, it’s not exactly “move along, nothing to see here”, but, at least so far, it’s close.

Nevertheless, the question remains: is this just the start of something really big? For example, are global markets signalling impending recession, which would mean that they do indeed have further to fall?

It’s clear what the principal cause of this weakness was: concern about the Chinese economy. There is an increasing belief that the world’s second biggest economy has slowed substantially (and to a far greater extent than the Chinese authorities would have us believe). This concern has been exacerbated by three (related) developments.

First, China has devalued its currency. Second, the Chinese share market has fallen precipitously and has now wiped out all of its gains for the year to date. Third, commodity prices have weakened sharply (a Bloomberg index of commodity prices is now at half the level it was in 2011 and no higher than it was in 1999).

The first two points have been described by distinguished economist Stephen Grenville as “rather minor short-term issues”. The movement in the currency has been very small, and it only partially offsets the trade-weighted appreciation of the yuan caused by the strong US dollar, to which the yuan was pegged. But it took almost everybody by surprise, and was interpreted by many as the first salvo in a possible currency war. China’s policymakers were apparently surprised by the global reaction to the small move and are rumoured to have made a commitment not to let the yuan weaken past 6.5 to the $US, about 6% below its pre-devaluation level and about 1.5% lower than its current level.

The Chinese share market bears little relationship to the Chinese economy in total, and its day-to-day movements frequently owe a lot to whether or not officials are intervening on that day. While the recent weakness has been staggering, the Shanghai composite is still up by about 30% in the past year (see chart).

Contrary to some media coverage, the Chinese consumer has little exposure to the vicissitudes of the market and Chinese companies do not rely heavily on the market for finance. While the market doesn’t appear to be telling us much about the economy, there is a risk that continued weakness will have an effect on confidence.

Every picture tells a story!

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The fall in commodity prices is also a concern. WTI (a grade of oil) is a case in point. After plummeting from more than $US100 a barrel in July last year to just $US42 in late-January (very much in line with previous large drops) it then bumped along the bottom for a couple of months (again very much in line) and then began to rise (still in line!). But then, about eight weeks ago, the story changed dramatically, with the price falling again, to $US38 in late-August. This second period of dramatic weakness is almost without precedent. Then, remarkably, WTI staged an astonishing rally in the last three days of the month, surging to $US49 a barrel. This is the largest percent gain in such a short period since Iraq invaded Kuwait in 1990.

The renewed weakness of commodity prices was taken by some as a sign that global economic growth may be faltering dramatically. It shouldn’t surprise that there is a strong link between commodity prices and global GDP growth, as shown in the chart. Importantly, however, there is no evidence in the chart that commodity prices lead global growth; no evidence that they warn when a recession is coming. The real doomsayers may concede this, but then argue that the commodity price information is instantaneous and the other indicators just haven’t caught up yet. But we have a wide range of real-time indicators these days, and none is suggesting that the world economy is teetering on the brink.

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So what then is going on with commodities? Well the relative weakness of the Chinese economy is probably playing a role; for many commodities (eg iron ore, aluminium, nickel and steel), China represents half or more of the global market. The following chart shows the very close link between an index of Chinese manufacturing and the price of copper. Incidentally, this index was reported as showing that manufacturing in China is now at a multi-year low; this is simply wrong. The index shows (approximately) how manufacturing is faring relative to its long-term upward trend!

But it’s not just the putative slowdown in China that is relevant, it’s also a shift in the composition of growth, away from commodity-intensive investment and construction and towards consumer spending.

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In addition, commodity prices are being held down by good old-fashioned supply and demand, with supply having taken off when prices were high through to 2011. Also, commodity markets are probably far more affected these days by “financialisation” – the actions of players who are not genuine end-use buyers or sellers.

So, we shouldn’t pay too much attention to the Chinese market, and there is no evidence that global economy is about to go to hell in a hand-basket.

 Of course, there have been other worries, including the ongoing Greek situation, some sabre-rattling from North Korea, a very weak second-quarter GDP result for Japan and the prospect of imminent tightening of US monetary policy. Let’s just say that the Fed is very unlikely to raise rates in September unless markets settle down very quickly. Current market pricing puts the chance of a September rate rise at around 40%.

Add to that list the fact that markets were looking a touch overvalued (although conventional measures don’t work all that well when rates, and hence yields on alternative assets, have been so low for so long), and you have all the ingredients of a correction.

This one, it is true, became somewhat disorderly, and a herd mentality took over. Some went so far as to suggest a possible re-run of the 2008/9 GFC. Recall that all major developed economies with the exception of Australia fell into deep recessions on that occasion, and that the global financial system came very close to complete collapse. There is not a shred of evidence that we are anywhere close to such a situation again.

This is the fourth major correction since markets turned in March 2009 (the last one was in 2012 in response to concerns about European debt). It may get worse before it gets better, but it is also possible that the last week of August saw the low point. While volatility is likely to remain high for some time, the fundamentals of corporate earnings and likely economic growth suggest that the market will be significantly higher a year from now.

 

Meanwhile, back in Oz

There was little of note in the domestic economic news, with the exception of the labour-market data, which continue to send off very confusing signals. The June data suggested that the unemployment rate may well be on the way down (it fell to 6%, the lowest reading in more than a year). But the July data showed a significant rise to 6.3%, the highest it has been since August 2002 (oddly, in both July 2015 and August 2002 the unrounded rate was 6.349%).

This alone increases the chance of further rate cuts, but going the other way was a continued fall in the exchange rate, which began the month at 72.9 US cents (having already fallen by 4 cents in July) and finished at 71.5 cents. Given that the RBA has been campaigning vociferously for a lower currency to assist in the rebalancing of the economy, this is a welcome development. And remember, what you lose on your overseas travel costs when the dollar drops you more than make up for in the value of your overseas shares. Interestingly, the fall in the Australian dollar in the past two months has been “all its own work”. Unlike the decline from August last year to June this year, movements in the past two months have been “home grown” and have not merely reflected a rising US dollar. As a result, cross rates have finally come down significantly.

The Reserve Bank left the cash rate on hold again on 1 September, and continues to be a reluctant cutter.

I have had to relent on my long-held forecast of 5800 for the ASX by the end of the year. 5500 now seems to be a more reasonable target. The currency has already hit my end-of-year forecast of 72 cents.

 

Note: this article draws heavily on a piece I wrote a week ago concerning share market volatility, in accordance with my status as a fully paid-up member of the John Fogerty school of self-plagiarism.

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