Is this a healthy correction?

Philip Saunders, co-head of Multi-Asset at Investec, asks if this is a ‘healthy correction’ or the onset of something more sinister

August 2015

The disorderly fall of domestic Chinese-listed companies from extended levels, followed by the surprise move by the People’s Bank of China (‘PBoC’) to adjust the renminbi’s fixing mechanism, unleashed what has turned into a full-blown growth scare. Prior weakness had mainly impacted emerging market assets and commodities, but this has now broadened to developed markets, which have experienced sharp declines.

So is this a ‘healthy correction’ or the onset of something more sinister? We believe that stock market concerns about the onset of a global recession are overdone and thus this episode is likely to prove to be the former.

This market cycle, overshadowed as it has been by the global financial crisis, has been punctuated by ‘panic attacks’ caused by concerns about imminent recessions. These featured US ‘double dip’ fears, worries about euro-zone disintegration and a hard landing in China. While it is true that this recovery has been weaker and less synchronised than in previous cycles, the evidence suggests that economic conditions are improving in the developed world at a sufficient pace to offset the deceleration in the pace of growth in the emerging world, which has been impacted by the sharp decline in the Chinese growth rate. Recent data from the US, Europe and Japan clearly supports this view and, even in China, recent data, such as that pertaining to house prices and property transactions, actually points to stabilisation. The PBoC has considerable scope to relax monetary policy further to mitigate downward pressure on economic activity in China, hence there is a danger that concerns about Chinese economic weakness have become exaggerated. Clearly negative psychology is driving markets right now.

Across the developed world, credit conditions continue to be loose and there are few signs of a credit crunch. In the past, credit crunches, as central banks tightened monetary policy to combat over-heating economies, typically caused recessions. These, in turn, caused forward earnings and price earnings of companies to decline. Corrections tend to occur when price earnings ratios fall, while forward earnings continue to move higher. Recent earnings dynamics in all the key developed market regions continue to show signs of improvement. Purchasing Manager Indices and other leading indicators are supportive and we have yet to see much of the impact of weaker oil prices on consumption.

Even prior to the developments in China that unsettled markets, investors had progressively been reducing risk in their portfolios from the levels in the first quarter. This has been evidenced in sentiment and positioning surveys, declining developed market government bond yields and a preference for defensive sectors within equity markets. This clearly didn’t prevent another severe bout of risk aversion, but the move is probably more mature than the pessimists fear.

So, macro fundamentals remain supportive, valuations are reasonable to good and investor positioning, already defensive, suggests a bounce-back in prices.