Month: October 2015

Q3 letter: China and Rates driving the market

Q3 letter: China and Rates driving the market

In our last letter, we stressed how economic turmoil in China could have far-reaching implications for the global economy.  Much of the past quarter’s market activity has been driven by this concern as global risk assets sold off in response to persistently weak data out of China.

We continue to view events in China as a top risk factor going forward despite aggressive attempts by Chinese authorities to prop up stocks and assure investors that markets are stabilized.  Much of the onshore Chinese market remains suspended and economic data points to substantial weakness. Stocks on the on-shore Shanghai exchange are about 30% overvalued when compared with the same securities trading in Hong Kong. Reports and analysis suggests the Chinese government continues to intervene in the market on a daily basis through its agencies and state owned enterprises. Restrictions on stock sales are still in place for many participants including company officers. The credit markets have grown significantly over the past few years, with private sector debt now at 227% of GDP (it was 116% in 2007). Most of this debt is related to real-estate in one form or another. In comparison, private sector debt in the US is roughly 180%. A rise in rates or the inability to roll over debt, would cause a significant shock to China’s private sector enterprises. Public sector debt levels appear more manageable, at 55% compared to 89% for the US. However, local governments are heavily reliant on off-balance sheet financing to fund infrastructure projects. If these vehicles were to fail and had to be bailed out, government debt could balloon to reach US levels. Given the Chinese market’s size, uncertainty in credit and equities markets has begun to affect perception of other emerging economies and has continued to depress commodity prices (where Chinese demand had once been the major growth driver).

Partly in response to these concerns, in September, the Federal Reserve chose not to raise interest rates (there was one dissenting vote). US stocks, which in previous years had rallied on dovish news from the Fed, reversed and sold off as market participants became spooked by Janet Yellen’s relatively gloomy press conference.  Most market participants had expected a rate rise and the Fed’s failure to deliver gave investors pause.

Despite some recent weaker-than-expected US employment data, we think it remains likely the Fed will raise interest rates at some point this quarter (possibly in November). Rates have been held steady below 0.25% for nearly 7 years now and the case for a punctuated normalization of rates grows stronger every month. We do not see room for meaningful raises next year as we would be in the middle of an election cycle (in an effort to remain non-partisan, the Fed prefers not to make major policy moves during election years). The Fed notes that levels of inflation are the biggest argument against raising rates and stubborn low inflation could potentially be a reason for them not to raise.

US equities markets remain approx 5% below the highs realized earlier this year and, despite an early October rally, we believe risks remain prevalent. We continue to urge US-based investors to maintain cautious allocations as valuations remain at cyclical highs and neither the business cycle nor the current interest rate environment are conducive to high risk investments in stocks or bonds.

While we think playing defense is prudent in this environment, increased volatility can often mean mispriced assets and buying opportunities, especially when sentiment turns negative and investors aggressively sell.  We will continue to closely monitor market moves and look to buy quality companies if they are sold indiscriminately.

As we are approaching the year-end, we remind clients to keep in mind calendar-year deadlines for 401k and retirement plan contributions. It may also be appropriate to review capital gains realized this year and discuss implications with tax advisors. As always, we would be happy to be part of the conversation.

 

Regards,

 

Subir Grewal                                                                                                 Louis Berger