The last week of August 2015 started with a bloodbath in global equities as the carryover from ongoing Chinese negative economic news and stock declines caused near-panic selling around the globe, with the US Dow Jones down over a thousand points around the opening bell (about 6.6%). Good explanations for the sudden plunge in US equities were tenuous. The best one could say was “Something in China*”. A Chinese slowdown had been unfolding for years, and Chinese equities started a rapid decline in mid-June, after a bubble-like run of a 150% gain over the prior 11 months, bringing them to a nearly flat performance for 2015 through 28 August 2015 (see chart 1 below). The jump in US equity volatility (VIX) was unprecedented on ‘Black Monday’ (24/08/15), with the rate of change in VIX surpassing all risk-aversion events of the past decade, including the Lehman crisis (see chart 2 below). In contrast to Monday’s ominous start, equities and oil prices ended up on the week, though sentiment remains fragile. What should we make of China now, and how does it affect the outlook?
Chart 1: Changes in China’s GDP (LHS) and Shanghai Stock Exchange Index (RHS)
Chart 2: Is China a bigger risk to corporate America than Lehman, Greece and US fiscal problems? Volatility of volatility index (VVIX) for the period from 2006 – 28/08/18
Sources for charts 1 and 2: Bloomberg Finance LP, Deutsche Bank Research, Torsten Slok.
For one thing, the 11% plunge in S&P comes after one of the longest historical periods of low volatility: we just had the narrowest five month range in more than 80 years and one of the longest periods without a 10% correction. Volatility in other asset classes such as currencies and bonds picked up too, but nowhere near the spike in equity volatility. It is not clear that the economic outlook for the US has suddenly changed with the previous week’s volatility, though this cannot be ruled out. The transmission mechanism from China to the US is small via direct trade as US exports to China are a negligible factor for US GDP. Similarly, direct financial market linkages are also minor, though a “sentiment” link (the CNN effect) via risk-aversion can be important, as investors reconsider risk-appetite in general.
From a policy perspective, central banks in the US and Europe are likely to remain vigilant in ensuring they do not contribute to risk-aversion, though their ammunition for actually easing financial conditions, beyond what’s already in place, are rather limited. Key Federal Open Market Committee (FOMC) participants already indicated in the last week of August week that the case for a September Federal Reserve (Fed) tightening has weakened, while European Central Bank (ECB) officials have called for countering any renewed downward pressure on inflation expectations due to China and the decline in oil prices, via more quantitative easing (QE).
US economic data have been positive, though not spectacular: GDP in the third quarter was solid at 3.7%, bringing year-on-year real growth to 2.7%, while orders for durable goods in July and preliminary readings on consumer confidence in August were strong. Similarly, US housing trends remain solid.
In China itself, economists are not expecting a hard landing. Chinese authorities are actively trying to stabilise their equity markets and are unlikely to let the CNY weaken much in the near term, as they now fully realise that their recent (minor) devaluation may have been a catalyst for last week’s global financial market volatility. Chinese economic data are predicted to pick up a bit in the fourth quarter, as the fiscal loosening that started in May and the sequence of interest rate cuts that started in March, kick-in. Nevertheless, the situation is hard-to-read in an economy that has been slowing since 2010, with debt totaling over 280% of GDP.
As the famous economist Ken Rogoff, co-author of the book “This Time is Different” concluded, every financial crisis stems from a simple problem: too much debt. The financial crises that started with the Lehman bankruptcy of 2008 (subprime debt), followed by the European sovereign debt crises of 2010-2012, may well have finally found their way to China in 2015. In all cases, these crises have led to deflationary impulses that course through the global economy and rattle financial markets.
In the current episode related to China, emerging economies and commodity prices are being hit particularly hard. The full effects for the US and Europe are not yet known but, at a minimum:
– Global interest rates are likely to remain low, as subdued global growth and inflation are likely for a period of time.
– In currencies, the USD should continue to appreciate somewhat, especially against the euro, commodity currencies and Asian emerging markets currencies, as the US is still likely to be the first to raise rates in the future, even if a rate hike is now delayed.
The “Dog Days of August” have had a vicious bite!
Written on 28 August 2015.