Financial markets have had a tumultuous start to the year. The epicentre has been the Chinese equity market and the sharper than expected depreciation of the yuan versus the US dollar. This raises a range of questions for an economist with a cautiously optimistic view on the outlook for 2016. To what extent is this a reflection of what is going on in the Chinese economy? If it is not driven by the Chinese economy itself, what is it driven by? What will be the impact on other economies, in particular the eurozone and the US?
If the fall in Chinese equities is not due to the Chinese business cycle, then what is it caused by?
Han de Jong Chief Economist
- China's economic trends do not justify the recent severe weakness in equities.
- We think that the soft landing in China is continuing while imports are showing early signs of a bottoming out, which is good for the rest of the world
- We expect Chinese authorities to regain control of the situation and calm markets
- The eurozone economy is growing nicely and expected to continue to do so
- Domestic demand in the US is strong, but manufacturing is weakening. We expect this to be temporary and for manufacturing to regain momentum
Chinese equities and the economy
Concern over the Chinese economy has troubled financial markets for some time. Whatever our view on China, we must bear in mind that its economy is complex, in several transitions at the same time and not as well-documented as more advanced economies. In other words, the uncertainties are significant, no matter what.
Having said that, our view has long been that the Chinese economy is experiencing a soft landing, not a hard one. But even this soft landing should be expected to be bumpy. Our interpretation of the data is that Chinese imports weakened significantly early in 2015. The effects of that were gradually felt in the rest of the world. However, in recent months, imports appear to have stabilised. In addition, the housing market seems to be recovering. If we are right in these views, then the recent fall of Chinese equities is not a reflection of the economic cycle.
I think there is at least circumstantial evidence that the Chinese economy is stabilising. For example, business confidence in the manufacturing sectors of Taiwan and Korea weakened in the first half of 2015 but has made a remarkable comeback since the summer. This is unlikely to have happened if Chinese economic conditions had deteriorated sharply.
A similar picture is emerging in German factory orders. China, and other emerging economies for that matter, are important buyers of German capital goods. Orders for German capital goods from non-eurozone countries fell sharply around the middle of the year, but have improved somewhat in the last three months.
Chinese import data also suggest that imports have stabilised in recent months after a sharp drop early last year. I am therefore inclined to believe that the negative impact of developments in the Chinese economy on the rest of the world is waning.
If the fall in Chinese equities is not due to the Chinese business cycle, then what is it caused by? It is always hard to determine that with much confidence. The Chinese equity market is volatile as it is dominated by retail investors who tend to behave erratically from time to time. A reasonable explanation is the uncertainty related to new and expiring stock market regulation (the introduction of ‘circuit breakers’ and the end of the sales ban introduced in the hectic summer of 2015). Not surpisingly, abolition of these circuit breakers and the re-introduction of the sales ban, presumably in combination with renewed stock buying by government-related entities have caused the stock market to stabilise by the end of the week.
Another reasonable explanation is perhaps China's foreign exchange policy. For a long time, the yuan was managed against the US dollar. In August, the Chinese authorities announced greater flexibility in their currency management. The yuan promptly lost 3% or so, leading to unrest in financial markets. The response of the policymakers was to tighten things up again. But in December, they announced that the yuan was going to be managed against a basket of currencies and a further weakening of the currency against the dollar was the result, although the extent of the yuan's depreciation has been modest. Since the start of this year, the pace of depreciation has gained some speed.
From an economic point of view, a change in China's FX policy does not seem unreasonable. As the dollar has appreciated strongly against most other currencies in the last two years, the yuan has also appreciated. On a trade weighted basis the Chinese currency has strengthened by some 25% from the start of 2010 to the beginning of last year. This appreciation more or less stopped in 2015. But it can perhaps be argued that some of the appreciation of recent years should be reversed.
The problem with Chinese FX policy is that any change and uncertainty unnerves financial markets. Markets are also concerned that China has started a ‘competitive devaluation’ and speculate what that could mean for other currencies, global inflation and China’s demand for commodities. Chinese policymakers are on a learning curve as far as communication with financial markets is concerned. Uncertainty is not what financial market participants want. And the financial flows that are potentially triggered by this uncertainty have the potential to become a tsunami or at least a tidal wave. This can be measured by the change in foreign reserves of China's central bank. Having started this century at just over USD 150 bn, China's FX reserves climbed to a staggering USD 4000 bn by the middle of 2014 but have declined since. They stood at USD 3330 bn at the end of 2015, dropping some USD 35 bn per month on average since the peak in 2014. However, in the last two months of the year, reserves fell by more than USD 100 bn per month, signalling nervousness.
The solution here is for Chinese policymakers to get in control again. Experience suggests that they will manage to do that, but this could take some time as it is, to some extent, a trial-and-error process.
The effects on the eurozone and the US
Some divergence is developing between the cyclical trends in the eurozone on the one hand and the US on the other. Recent eurozone data is upbeat. The European Commission's index of economic confidence, which combines business confidence in all sectors of the economy and consumer confidence continued its modest uptrend in December. The index stood at 106.8 in December, up from 106.1, and the highest level since early 2011. Other European data has recently also been encouraging. German orders have strengthened for two months in a row after some weakness around the middle of the year. Retail sales are also growing at a reasonable pace. This suggests that the eurozone economy continues to benefit from the tailwinds we have highlighted often and is not particularly affected at this stage by the problems in emerging economies as domestic demand is now strengthening and growth has become broad based. Financial market turmoil spilling over from China could, of course, upset this picture, but we expect the turmoil to subside.
The picture in the US is somewhat different. The industrial sector is relatively weak as evidenced by the divergence between the US manufacturing ISM index and the eurozone's economic-confidence index. Weakness in US manufacturing is probably the result of the appreciation of the dollar over the last 18 months and the effects of the challenges for emerging economies. Having said that, the domestic economy remains in very good shape. The labour market continues to strengthen as evidenced by the very strong labour-market reports over November and December and consumer demand is solid. We therefore think that the US manufacturing sector will overcome current weakness before too long.
Inflation is very low almost everywhere. This allows key central banks to keep policy rates at very low levels. Eurozone core inflation remained stable in December at 0.9% yoy, while headline inflation was also steady at 0.2% yoy. The recent drop in oil prices suggests that headline inflation may ease in the near term. This worries the ECB and we still think it is likely that they will take modest further easing action, most likely in March, and most likely consisting of another cut in the already negative discount rate.
Having raised rates in December, the Fed is likely to sit on their hands for a number of months. Assuming our cautiously optimistic outlook for the global and the US economy materialise, we still believe the Fed will raise rates further this year, but the next step should not come before June.
All in all then:
- We think that the slide of Chinese equities is not justified by Chinese cyclical developments but more related to uncertainty over China's FX policy and the generally relatively high volatility of the Chinese stock market coupled with uncertainty related to stock market regulation.
- We expect Chinese policymakers to regain control over expectations related to their FX policy and bring calm back to financial markets.
- We think that the Chinese economy continues to be on track for a soft landing and that Chinese imports are showing signs of bottoming out, which is good for the rest of the world.
- The eurozone economy is growing at a reasonable pace and does not appear to be affected at this stage by financial market turmoil or any negative trends in the Chinese economy. We expect a continuation of the recent developments.
- The US manufacturing sector has softened, most likely as a result of dollar appreciation and problems in emerging economies. But domestic demand remains robust and we expect conditions in the manufacturing sector to improve any time soon.
- Inflation remains very low almost everywhere. This is a reason for us to expect the ECB to ease a little further during the coming months and the Fed to keep policy rates unchanged at least until June.