Who poked the bear?
August, unfortunately but concisely, was summed up in two words – ONE DIRECTION. Unfortunately investors weren’t singing and giggling like star struck schoolgirls as markets the length and breadth of the planet literally went, ONE DIRECTION!
Bourse boards burned red across the globe as a massive unwind wiped off 5 trillion dollars in value across major asset classes. It was red everywhere except in China where, strangely, it rained green! Fun fact - Red is green and green is red for our northern neighbours. As red is an auspicious colour in Chinese culture, they have it the other way around.
Mr and Mrs Lee are clearly not having a good day at the races. Neither did 90 million of their comrades last month (being the last estimate of retail investors in China who make up 80% of the stock market's participants).
Volatility surged as US indices; range bound for all of 2015, broke down key technical support levels in a hurry and entered correction territory. Indices globally corrected significantly with some such as Germany’s DAX, Portugal’s PSI and Dubai’s FMG (amongst others) even dangerously flirting with the mouth of the bear (a 20% drop in prices is classically defined as a bear market). And nobody wants to flirt, dance, hug or even be BFFs with a hungry 1000-pound bear! Emerging market assets and currencies were torpedoed and commodities (hard and soft) sank even deeper. Gold (with its 5,000 year old reputation as a flight to safety) registered, curiously, just a blip. Little known Kazakhstan even made the headlines when its currency, the tenğe, plunged 25% in one day as its central bank removed the US dollar peg. Let’s ask the world’s most beloved Kazakh what he thought?
The ASX 200, already on a short term down trend since May 2015, breached the psychological 5000-point mark for the first time since July 2013 before paring back some losses but still finishing down 8% for the month. Banks with their declining earnings, contracting margins and additional capital raising to bolster their balance sheets (and very likely their loan books heavily exposed to the housing /property markets) were big contributors to last month's slump while the energy and commodity sectors continued to pay the price for softening demand and oversupply. It is worth mentioning that amidst this gloom, the materials sector (names like Asciano, Qantas, Sydney Airport, Transurban) was in fact, fairly resilient during this period. Mid-caps too bruised a little less than the others, with our mid and small cap exposures in portfolios providing relative stability versus the blue chips. The AUD, typically a victim of major "risk off" events, slumped another 2.5 cents as a result. Some Reserve Bank dreams do come true apparently.
So back to the question posed at the start. Who did in fact poke the bear? Fingers were pointing resoundingly at China’s Yuan devaluation, on August 11th, as the culprit. Bear in mind (no pun intended) it’s not hard to irritate a hungry beast who’s been on a diet since 2008, especially with markets already as skittish as they are. Specifically, WHY would said devaluation spook the markets? Investors interpreted the action as China's indirect admission that its economy is definitely slowing down (notwithstanding questionable, government manipulated statistics) materially enough to jeopardize its precious exports sector, on the back of which the nation experienced two decades of phenomenal growth and most of the planet ended up being ‘Made in China’. This translates into a two pronged source of worry for emerging market type nations (and you too, Australia):
1. Those that provide the raw materials/commodities for China’s manufacturing juggernaut (and finished products even) are suddenly not able to sell as much as they like and consequently don’t seem like attractive investments themselves to outside investors. This “unattractiveness” can trigger fund outflows from these nations and inevitably lead to unsavoury economic situations.
2. The Yuan going cheaper affects these nations’ (Vietnam, Thailand, South Korea & Malaysia) competitiveness in the export sectors for rival goods they produce and some will be tempted to devalue themselves. End result? Refer to point 1.
A “currency war” was the most publicised reason and one thing for certain with ol’ Mr. Market, when the tide goes out somebody will be caught with their pants down. So with a bit of Buffett in mind and for the sake of (mostly) intelligent discourse, let’s put across a couple of other scenarios as to why China may have done what they did.
Was the “re-peg” part of China’s long term currency management plan?
China, has for years expressed interest for its Yuan to be taken seriously as a global reserve currency specifically with having it admitted into the Special Drawing Rights basket of currencies by the IMF, and in fact would prefer to see the Yuan appreciate! Maintaining a strong currency will prevent capital outflows, something the Chinese (and Australian property!) know all about. Engaging in cheap currency tactics will definitely be frowned upon and would hurt their membership ambitions. However, because the Yuan is pegged to the dollar and the USD has gone through the roof in recent times (naturally dragging the Yuan up with it) the rise may have been faster than the Chinese monetary authorities would prefer. As such, intermittent devaluations would be a necessary evil for the bigger picture balancing-act
Were the Chinese creating a smoke screen?
What conspiracy theory is this?! A very capable investment manager put this across. The Chinese are known to have vast hoards of foreign exchange reserves and are keen to put this deep war chest to work to spur domestic consumption, in order to plug the hole in its declining exports sector, which it is now creating. Though, in order to do so would require the conversion of these reserves, firstly, into domestic Yuan before administering a monetary needle in its economic bum. The Yuan is traded both onshore and offshore (more on this another time but try to keep up). The re-peg down onshore created even more selling pressure on the off-shore traded Yuan (the one the international market has access to), as speculators were convinced that even more devaluation was imminent. Could the Chinese whisper (which resulted in further Yuan devaluation) have given China the slick opportunity to sell its foreign reserves and buy back Yuan on the cheap (and get as much of it as possible in the process)? Is it also coincidence that China’s FX reserves have been steadily declining even as I write this?
<pHow did some of our recommendations do during this very challenging month? Our portfolio strategy of diversifying into small to mid-cap stocks (and not just fan favourite blue chips) resulted in some noticeable “offensive defence” when contrasted against the overall domestic market. While there was no avoiding getting caught in the downdraft for some of our Asian investment partners, this was in fact pared back by the resiliency demonstrated in our wider global and international infrastructure plays. Bonds held up really well, with not so much as a dent, putting proof to the defensive strategies in our clients’ portfolios. There’s an old Kung Fu maxim that goes “the hand which strikes also blocks”. Confucius says a lot of things but he didn’t come up with that one. All in all, our portfolio positioning has pleasingly held up very well, particularly when compared to the traditional stockbrokers’ menu offering of a selection of dividend crusted Aussie mains with a side of term deposits.
All eyes are now on the US Federal Reserve as they descend upon, quite possibly the most anticipated committee meeting of the year, where the financial world will finally have the answer to the most asked question in recent times – will Donald Trump make America great again? Sorry, I meant will the Fed finally begin a cycle of rate RISES? Given the month we’ve had, it’s no secret the market is now expecting the Fed to stand down. It’s also worth noting that market rate expectations are also well below the Fed’s median projections. As we’ve mentioned before, if expectations don’t converge (and history has shown this to be true more times than not) and given the overly long bull market fuelled on massive, unprecedented credit expansion and heavily skewed one way fund flows, coupled with no clear exit strategy (due once again to sheer lack of precedence), there could be some reverberations whether immediately or in the near term. That was a mouthful
As conditions of slow demand and slack continue to persist, the opportunities brought about by extreme asset pricing are still presenting themselves. But given an obviously slowing China and possible US rate rises, patience and very careful manoeuvring will most likely be the order of the day for investors going forward. That and a good defence! For our more conservative and balanced investors, it is steady considering the volatility over the past 18 months. For our more aggressive, long term growth investors and those looking to set portfolios now, a cautious knee deep wade into beaten up quality investments has been the theme of recent discussions. Albeit with plenty of chips kept to the side, and not the potato kind either.