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Economic Outlook | Fall 2015

China and Central Bank Influences Around the Globe


Recent events in China and their corresponding impact on markets around the world, especially heightened volatility in the U.S., gave investors a moment of pause. We believe that market anxiety, while understandable, is misplaced as key economic and earnings data remain largely intact, and we expect central banks to continue to employ a variety of monetary policies to address the specific needs of their respective economies. From the U.S. to Europe, Japan and China, central banks are using the tools at their disposal to address specific concerns. In doing so, they are driving growth in equity markets around the world.

While it’s difficult to call a bottom and predict the near-term path of markets in which sentiment is largely driving the moves, it is important to continue to focus on the fundamentals, which we think will ultimately prevail.

Coping With Volatility In China

Observations on recent market volatility and China’s impact
Recent events in China stem from much broader dynamics that have been influenced by China’s central bank and government activities. China’s several-decades-long export miracle ended years ago as its currency appreciated and its input costs increased. Importing nations sought other markets from which to purchase goods or grew their own manufacturing bases. Confronted with declining exports and a tightly controlled economy slowing more than expected, the Chinese central bank initiated a series of currency devaluations in August intended to stimulate their economy by making their products more attractive overseas and to help reduce some of the dislocations resulting from the long-term transition to a more consumption-based economy. However, we should not forget that such devaluations only offset a small fraction that the Chinese currency has experienced over the past decade due to the fact that it was pegged to the appreciating U.S. dollar. In other words, relative to other Asian emerging market currencies, the Chinese currency remains much stronger on a relative basis and has simply attempted to gently move away from being tied to the U.S. dollar moving forward.

In order to stabilize growth and restore order to China’s nascent stock market, the Chinese government had already initiated other measures such as reducing reserve requirements and restrictions on equity trading. These steps, in turn, raised concerns that a steep decline by the second-largest economy in the world would create a contagion across the globe. Chinese investors began reacting in June, but the spillover effect hit suddenly and unexpectedly in August.

The Chinese economy remains fragile. The government and central bank are responding with a wide range of policies to reassure investors and maintain confidence in the equity markets. In addition to providing substantial liquidity, they have further eased bank reserve requirements, loosened regulations on margin lending, suspended IPOs and encouraged those shareholders with more than a 5% stake not to sell their shares for at least six months. In a renewed commitment to public spending, the government will provide up to 1 trillion RMB (yuan) to jump-start infrastructure projects.

But China remains saddled with excess and imbalance. Despite the government’s continued efforts to maintain stability, growth may be further impacted. Expectations are that the Chinese economy will slow to a 3%-4% pace by the end of the decade—still better than most advanced economies but far from the export-fueled decades when double-digit growth was the norm.

Strong Dollar Likely To Slow U.S. Growth

A stronger dollar hurts manufacturing businesses and large multinational corporations because it stimulates imports and reduces the competitiveness of U.S. exports—thereby slowing U.S. economic growth. A good rule of thumb estimates the impact of a 10% rise in the tradeweighted value of the U.S. dollar as causing approximately a 1% reduction in U.S. real GDP over time.

Midsize companies, however, whose business activities are located primarily in the U.S., are less impacted by a strong currency, and their earnings growth has generally been stronger than that of multinational corporations. We continue to favor midcapitalization stocks as a result. It’s also worth noting that more than 90% of all U.S. M&A activity is happening in the mid-cap segment.

Overall, the dollar should not be a real concern for investors. The Fed is watching it closely, and has signaled that it will take into account the dollar’s relative strength when formulating its monetary policy.

U.S. Economy Continues To Improve

The U.S. economy is improving, and the current market activity should be considered a pullback amid an uptrending business cycle. The economy is making steady progress, with an improving labor market and signs of accelerated consumer spending. Housing market activity in the first half of this year grew faster than the growth rate of the entire U.S. economy overall. American consumers continued to reduce household debt as homeowners’ equity rose, and U.S. household net worth rose to its highest level in history. Following the addition of 3 million jobs last year, the U.S. is on a path to add another 2.5 million jobs in 2015. We are seeing early signs of wage pressure, not necessarily in hourly wages but in other data such as the higher quit rate, which is often seen as a precursor to higher wages.

Against this background of relatively stable growth, we believe that the Fed is likely to make adjustments gradually, in a series of steps through the end of 2016. As the steepening yield curve will benefit lenders, we are bullish on the financial sector. Other sectors that we currently favor include healthcare and technology.

Oil Prices To Stay Low For Now

More than a year after the sharp drop in price, the world’s supply of and demand for oil remain unbalanced. The decline in oil prices is not itself a bearish indicator and, in fact, is a positive development for most of the global economy. However, many view the recent sell-off in oil as an indicator of a global economic slowdown. We disagree. While countries like China are becoming less energy intensive given the shifts in its economy, global demand for oil is actually up this year. Declining oil prices are more a reflection of oversupply than they are an indicator of economic softness.

A Positive Outlook For Growth In Europe And Japan

We expect that European equity markets will continue to respond favorably as the European Central Bank maintains its policy of quantitative easing. We see the recent decline in the euro as a result of these policies rather than an overall currency devaluation strategy, and believe it will find a bottom soon.

Greek Deal A Positive For Europe

Despite the controversy and the potential for popular unrest over the terms of the deal, the Greek debt resolution is a positive outcome for Europe. It’s now much less likely that Greece will exit the eurozone, which will avoid a negative impact on eurozone real GDP growth during the second half of 2015. Some uncertainty still remains, as the Greek debt is unsustainable according to the IMF, and will have to be restructured in some way. This is likely to take the form of extended terms or lower interest rates on such debt rather than an outright “haircut” for creditors to allay the objections of some countries, such as Germany.

Exciting Prospects For Japan

The Bank of Japan has also been using monetary stimulus, and Japanese markets have responded. The Nikkei has outperformed the S&P by close to an 8-1 margin on a year-to-date basis. As the year progresses, the central bank is likely to reload and come back with additional market stimulus in the second half of 2015 or in early 2016. We do not expect the yen to weaken significantly from current levels, as Haruhiko Kuroda, the head of Japan’s central bank, has stated that the yen does not need to drop down much further. We are overweight in Japanese equities within our portfolio.

Throughout The World, Uncertainties Remain

As always, there are many reasons for investors to be cautious. We don’t know for sure that the Chinese stimulus efforts will be successful, for example, and continued volatility in the equity markets could damage investor confidence and conceivably delay the economy’s eventual recovery even further.

The impact of geopolitical instability and conflict is another perennial concern—the threat of war between Russia and Ukraine, for example, had a significant impact on Germany in the first quarter of this year, one that any renewal of tension is likely to repeat. The market considers the Iran nuclear agreement to be a done deal, but it is still opposed by many in Congress. The president has said he will veto any attempt by Congress to stop it.

Finally, despite the positive growth surprise in the second quarter of 2015, the Greek economy still faces some significant growth challenges this year as it incorporates the substantial structural reforms demanded by the IMF, the European Commission and the ECB in return for approval of a third bailout package. (An unraveling of the deal would be a big negative for Europe.) On a positive note, the Chinese government has expressed some interest in making further investments in the Greek economy.

If that happens and other countries follow suit, it should help the Greek economy recover faster. Russia has already suffered declines of 9.4% and 6.7% real GDP during the first and second quarters of 2015, respectively, and its assertive foreign policy may be constrained by continuing sanctions. A change in policy by Putin would also be a big positive for Europe.

What This Means To You

Markets around the world are going through varying stages in their economies. Recent volatility in China and other markets only reminds us that we need to focus on the fundamentals and that central banks will employ measures that they believe best for their conditions. As investors, we should keep our eyes on the long term and ensure we’re leveraging the value of a diversified portfolio.

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