China!

When the markets opened on the first market day of 2016, we were glad that we had not re-entered China's equity markets since we sold our China positions last August. We were also glad that we did not hold any emerging-market positions in our International and Global ETF Portfolios. We did consider participating in the fourth-quarter recovery in China's markets engineered by the authorities' heavy intervention, but the risks were judged unacceptable. The steep market pullback at the beginning of this week would have been even greater had there not been a new circuit-breaker system in effect. A marginally weaker Caixin General Manufacturing Purchasing Managing Index for December was cited by many as the leading cause of the pullback. We would give greater weight to the scheduled expiry (January 8) of the share-selling ban on major shareholders. The selling in advance of that date—until the circuit breakers kicked in—reflects the manipulated nature of current prices. Market-clearing prices could be considerably lower.

The government obviously does not wish to see a further setback in China's equity markets and is again taking action to prop them up. A setback would be understood to reflect a lack of confidence in the economy and in the government's economic and regulatory policies. Yet today (January 7) following Wednesday’s steep declines in global markets, Chinese equity markets fell a further 7% until circuit breakers again closed trading. The government is signaling that it is considering limiting the proportion of shares that major shareholders can sell during a set time. China's state-owned funds were reported as supporting the equity markets while state-owned banks were intervening in the foreign exchange market to stabilize the onshore yuan. There may well be short-term trading opportunities ahead for China equity ETFs that are currently very heavily oversold, but we continue to be very wary of markets in which price discovery is so limited.

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On the macroeconomic front, the reported growth rate for the economy is likely to be the same or very close to the third quarter's 6.9% annual pace. This rate masks a continuing moderate slowing in manufacturing offset by strong nonmanufacturing sector growth, an improvement in exports, and strong consumption. However, the Caixin Services PMI for China also eased in December. Government policies are expansive and clearly intended to infuse confidence in the economy. There are some positive developments. The December high-level meeting of the Central Economic Working Conference agreed on a welcome emphasis on supply-side economic reforms. Capital market reforms continue to progress. However, the tensions between maintaining the communist political system and moving towards a freer market economic system add a significant risk for the medium and long term. The geopolitical risks posed by the South China Sea dispute between China and Japan are also a significant concern.

While China's economy is undergoing a significant transformation, China will remain, together with India, a global growth leader. The slowing of Chinese demand for the exports of the emerging markets, particularly raw materials and commodities, continues to be a major headwind for those economies. The emerging-market equity benchmark ended the year down 7.68%. All emerging-market regions fell in 2015, the worst being Latin America, which declined by 11.3%. Thailand dropped 18.56%; Poland, 17.55%; Brazil, 15.09%; Turkey, 14.18%; Indonesia,12.33%; Taiwan, 11.39%; China, 9.48%; and India, 3.32%. Positive gains were registered only by Hungary—a remarkable 48%—and Russia, 17.19%.

While economic growth in most emerging-market economies should be moderately higher this year, their growth will likely be well below the pace experienced in the years preceding the financial crisis of 2008. The slower growth of China's demand for their exports, heavy debt burdens, the strong US dollar, and higher US interest rates will continue to hamper their growth. At present emerging markets on the whole do not look attractive to us. Going forward, we will be paying particular attention to those that are following sound economic policies, pursuing economic reforms, and shouldering manageable external debt burdens.

About the Author

Chief Global Economist
bill [dot] witherell [at] cumber [dot] com ()