Is it really all China's fault

22 Feb 2016

By Shadforth Financial Group

The Australian market got off to a rocky start in 2016 and much of the blame was placed on China. A government devaluation of China’s currency, combined with a sharp decline of China’s share market, sent shock waves around international investment markets and triggered a belief that this was ‘proof’ of a ‘hard landing’ in China.

The economic development of China continues to evolve so it should not come as a surprise that there are bumps in the road and if we take a step back and consider the bigger picture it becomes considerably less gloomy.

China’s share market collapse — or has it really?

As can be seen from chart one, China’s share market began rising sharply in October 2014, peaked in June 2015, and then declined sharply. This was no doubt a painful journey for many of the smaller retail investors in China who used borrowing to try to increase their gains. However, if we look over a slightly longer term, as shown in chart one, then the rise and fall of China’s share market begins to be seen in a different light. Indeed, China’s share market performance, over the three-year period shown, compares relatively favourably to other major international share markets.

Chart one: Share market performance (2013 - 2016)

Source: Bloomberg, IOOF Research

An economy in transition

Recent economic data released in China indicates relatively weak industrial production and a slowing in the growth rate of gross domestic product (GDP). This has generated some concern among investors, which has led to share market weakness, lower commodity prices and a drop in traditionally riskier currencies. The Chinese Central Government’s five year plan is very clear; move from a capital-intensive manufacturing-driven economy, to one which is consumer and services focused with an expectation the GDP growth rate will gradually slow towards five per cent as the economy transitions.

To help stabilise the Chinese markets and economy through the transition, the Central Bank has allowed China’s currency, known as the Renminbi, to devalue against the US dollar. Importantly, this devaluation is only relative to the US dollar as other major currencies, as shown in chart two, weakened more against the US dollar.

Chart two: Major currencies vs US dollar (2013 - 2016)

Source: Bloomberg, IOOF Research

As China is Australia’s biggest trading partner, the concern that the demand for our commodities and the flow-on effect on the economy is very real. However, we need to bear in mind that mining companies are behaving rationally at this point in the cycle, with marginal producers being squeezed out and mines closing. This is a healthy and normal part of the cycle and will rebalance the market, ultimately leading to stable prices and leave industry survivors like BHP Billiton and Rio Tinto in a good position for the next up-cycle.

While China continues to emerge as a developed economy there will be growing pains. The government needs to continue introducing sophisticated financial instruments despite the volatility this can generate in its share market. This volatility tends to blur the underlying fundamentals of the economy and share valuations. The Chinese economy should enjoy GDP growth of four to five per cent on a much larger base over the medium term, and we believe the volatility provides investors with a long-term horizon a good opportunity to buy quality shares cheaply. Furthermore, China’s demand for commodities will continue to be substantial.

Volatility in China is expected given the transition of their economy but low commodity and oil prices are exceptionally positive for global growth because of their positive impact on production and consumption — ultimately this is very bullish.

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