Panic and euphoria in China

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Sara Salim's picture

The markets are in panic mode for the first time since 2012 according to Credit Suisse analysts. There has been a slight uptick in global industrial production, but this is overshadowed by investor nervousness about China’s continuous declining growth. Although there have been announcements of easing measures, there remains uncertainty surrounding the quality and reliability of China’s economic data. On top of that, financial risks in Brazil appear to be a worse threat than China given its external deficit and huge foreign currency debt. As the Brazilian real falls to an all-time low, Brazil’s debt is spiraling out of control. Overall, emerging market currencies are weakening in light of domestic problems and tightening dollar liquidity that will intensify if the Fed moves toward a rate hike by the end of this year. With the backdrop of a strong dollar, exporters are seeing their trade revenues fall and at the same time the growth in export orders are at its slowest since the recession in 2009. Slowing emerging markets are feared to present deflation to developed markets.

Source: Credit Suisse on http://www.marketwatch.com/story/markets-are-back-at-panic-levels-says-credit-suisse-2015-10-02

This panic episode is more formally established when the Credit Suisse Global Risk Appetite Index falls below -3 which happened on the 27th of September 2015. In the simplest sense, the index measures if investors earned additional returns over the past six months by skewing portfolios toward risky assets away from safe assets. The graph indicates that the two previous panics were caused by worries of a Eurozone break-up back in 2011-2012 and the fall of Bear Sterns during the global financial crisis in 2008. Market participants respond adversely to shocks, and while sometimes the reaction is appropriate, it usually is an overreaction to short-term events. If it is an overreaction, there is opportunity for investors to purchase risky assets at a discount. Investors however believe current evidence justify a bleak and muddled long-term view with the possibility of further panic with no investment opportunity in sight.

I believe it is not all doom and gloom as markets are overreacting. Stabilization is likely because policy makers outside of the US will provide stimulus for risky assets in the fourth quarter of 2015.  The Chinese authorities are aggressively easing conditions with increased lending, lowered interest rates and reduced reserve requirements, which would lead to stabilization even if large rebounds are not seen. In Europe, extended quantitative easing is likely to last till September 2016. Furthermore, developed markets have relatively limited spillover effects from emerging market weakness. Chinese import demand as a share of GDP of Developed markets is low - In the EU it is 1.0% and in the US it is 0.7% and Chinese financial markets are largely closed off to the rest of the world.

From the graph above, the trend indicates that episodes of panic precede euphoria, not necessarily immediately but will eventually. Euphoria is when the index level hits 5 and above. I don’t think the Index will fall further below -3 similar to previous incidents of panic. Instead it will move towards 0 by the end of this year. What happens next depends on what happens in China. The Chinese authorities are diligently reforming toward economic liberalization to achieve its geopolitical ambitions. Although economic growth is in structural decline, annual growth in discretionary consumption is predicted to exceed 7% between 2010 and 2020, in the context of annual aggregate household income of $5 trillion [1]. Profits in consumer industries like furniture, electronics, food & beverage grew from early 2015 to date. Westpac-MNI’s monthly consumer survey claims that the Chinese are more confident about their finances and the business environment – the most optimistic since May 2014. The average individual Chinese consumer is not perturbed by aggregate national statistics. Soon, it will transition from an export-oriented economy to an urban consumption-focused economy with market-determined exchange rates. Its weakness in exports and the industrial sector will have a diminishing impact on income and spending. When China (and global markets) successfully perseveres with these painful Chinese reforms and enjoy the fruits of labor by the next 3-5 years, we will be in the next euphoria.