The global equity sell-off has been brutal so far in the year 2016. Many global equity indexes have plunged into bear territory. There is enormous panic and fear about a forthcoming global recession. Are we going to have a recession? I don’t know. But I don’t think so. But then, I don’t know. And this is how investors worldwide are feeling right now – they don’t know. This “don’t know” phase is quite a dangerous phase for worldwide capital investments – because companies will be unwilling to commit to major investments if there is uncertainty, especially if there is uncertainty in global asset prices.
But let’s examine some of the major panic-spots, as I would like to call it, right now:
China: Chinese economy is growing slowly. Now, there is a difference between growing slowly vs. no-growth or negative growth. In this case, Chinese economy is still growing, albeit quite slowly and understandably so. Because of this slowdown in the Chinese growth, there is a worldwide re-pricing of many major assets. For example, China consumed almost half of the global iron-ore production in the past decade. Now that China is growing slowly, how much will the fair value of a metric ton of iron ore be? And that question is exactly what is being answered by the markets right now – meaning, there is a strong re-pricing of assets going on globally, particularly of many commodities, based on supply and demand. And many global companies made a classic mistake of over-producing commodities during the boom time without forecasting a slowdown in the demand growth. This along with the often-generated market over-reaction, not to mention the gazillion modern leveraged financial products that have been created in the market, has caused an extreme downward spiral of many commodity prices. But if you wither out the market over-reactions, I believe that some of the slowdown in China will actually be compensated with a slight growth in a handful of other countries like India, Indonesia, South Korea etc.
Now, with respect to the Chinese retail investors chasing the equities higher without any fundamentals to support them over the last two years – I think this is in the rear-view mirror now. After a more than a 50% plunge in the Chinese stock markets within the last year, the needed correction is almost done. There may be a little more shakeout, but I believe most of the correction on this front with respect to the crowding retail investors has been done already.
My biggest fear when it comes to China is their banks’ exposure to high risk loans within their domestic economy that could turn into bad debts. While China has massive forex reserves, with almost $2 trillion of them in liquid assets to handle any risk to their money-supply and credit markets, with sufficient capital controls in place, a mere sign of any major trouble to any major Chinese financial institution could have enormous unintended consequences with ripple effects across the globe. It is in this space one has to watch carefully, though the communication from the Chinese authorities has been almost nil, if not incomplete, in this space to re-assure global investors.
Now with regard to US banks, I don’t think there is much direct exposure on the loan-front to the Chinese economy. So any talk of a US banking crisis due to China is unwarranted.
The other major concern I have is how the Chinese authorities will manage their currency this year. China cannot steer its economy to its growth target this year without devaluing their currency. How they would devalue their currency is the billion-dollar question? If it is a major one-off devaluation, then there is a high probability that that will cause a jolt to world financial markets; and panic and competitive devaluation could follow, thereby risking global growth. If it is a gradual devaluation over the course of the year, then they might be able to sail through the muddy waters. This is something that we need to wait and see to get a little more data and to understand where exactly they stand with respect to their transformation to a more private retail consumption and services based economy.
I will continue with my discussion on the current status of global crude oil prices and its effects in my next
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