Jan 13, 2016

Anatomy of the Global Sell-Off

The new year kicked off with a global sell-off when China reported a lower manufacturing PMI. Investors fear that a potentially competitively devaluating yuan could lead to other emerging market countries devaluting their currencies and fear of a Chinese deflationary wave spreading globally.

The Trigger
The global sell-off started on Monday, January 4, when China reported a lower manufacturing Purchasing Manufacturer Index (PMI), down 0.4 points to 48.2 in December (from 48.6 in November). A PMI of over 50 indicates expansionary territory, whereas less than 50 is contraction territory.This caused the Chinese currency (the yuan), which is pegged to the USD (but is allowed to float within a band) to devalue. The knock-on effect and investor fear is that a potentially competitively devaluating yuan could lead to: first, other emerging market countries competitively devaluing their currencies (leading to a 1998 currency crisis and sovereign bond defaults) and, second, the fear of a Chinese deflationary wave spreading globally.

The Concern
The fact that the most developed market central banks around the world are already at zero or negative real interest rates, and the U.S. Federal Reserve is on a divergent path of raising rates, has sparked a global sell-off. The reason for this is if China causes a deflationary wave which spreads globally, central banks will not be able to respond in a timely manner to stem the tide. This could trigger a deflationary spiral causing consumers to stop spending, companies to stop investing, global GDP growth to come to a screeching halt and the profitability of companies (which in the long run is the only driver of stock market returns) to collapse.

Our View
Quite a start to the new year, as China has led the sell-off down 14.5% year to date in local currency. Stock markets around the world have followed and are down anywhere from 6% in the U.S. to 10% in Hong Kong, with Europe in between. What we're watching for is: first, despite uncontrollable yuan depreciation being the catalyst for the fear and market sell-off, it has depreciated a modest 1.2% and has actually appreciated 0.3% in recent days. Second, while on the surface, the Chinese manufacturing PMI disappointed market participants, a closer look reveals that China’s transition to a more domestically driven economy continues to show progress. This is shown by the services PMI which improved in December to 54.4 from 53.6 in November. Nonetheless, China must carefully manage this transition to avoid a hard landing and it has ample room to manoeuvre. In light of this, from China's perspective, we expect the economy to remain stable and provide capital allocation opportunities as valuations are extremely compelling with what we consider a sell-off that is overdone based on the fundamentals.

For the developed markets while many investors worry about the divergence between the Fed and European Central Bank (ECB), we believe that as 2016 unfolds there will be convergence between the two central banks as both continue the fight against inflation, which is too low. For the Fed, it means a very slow pace of interest rate hikes, slower than the market anticipates, and for the ECB it means continued aggressive quantitative easing measures and negative interest rates, more than the market anticipates. For stock prices, in general, we believe there will be an upside surprise.

Most Importantly, for our clients, it means we are active in this sell-off looking beyond the fear. We are cutting through the noise, utilizing our disciplined investment process as our compass in a confusing and volatile world, to add to existing positions and find new opportunities with great risk/reward profiles over the next three to five years.

Our latest Quarterly Outlook Commentary, written exclusively for our clients, will be released this month. The Outlook provides a deeper perspective into recent market developments, our outlook on where we're finding pockets of opportunity in a very volatile environment, and highlights companies we hold in our portfolios. If you wish to receive a copy of our Outlook Commentary, contact us at (403) 234-0005, or at [email protected].