The View
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Don’t blame flimsy trade war truce – exposed by Huawei arrest – or the Fed for market turbulence. Instead, look to China’s economic woes

  • Nicholas Spiro says doubts about China’s economy, as well as Beijing’s confused response to the slowdown, are the real source of investor anxiety, not recent developments
PUBLISHED : Tuesday, 11 December, 2018, 12:53pm
UPDATED : Tuesday, 11 December, 2018, 12:55pm

Another week, another tumultuous spell of trading in financial markets. Last Monday, the benchmark S&P 500 index joined a global rally in stocks in response to an apparent easing of tensions in the US-China trade war, only to plunge 3.2 per cent the following day partly due to mounting concerns about the health of the world economy. Last Thursday, the Stoxx Europe 600 index, Europe’s leading equity gauge, suffered its worst one-day performance since Britain voted to leave the European Union, in June 2016, yet quickly rebounded on Friday, enjoying its best day in five weeks.

The surge in stock volatility, which began in February, has intensified since early October and has spread to other major asset classes, which are on track this year to suffer their broadest losses since the 1970s, according to data from JPMorgan. Adding to the uncertainty is a raging debate among investors and analysts over the causes of the wild gyrations in markets.

One of the most frequently cited reasons for the turmoil is the fear that the Federal Reserve is too hawkish. Treasury yields have fallen sharply since early November, so much so that part of the yield curve inverted last week for the first time in a decade, usually a sign of a coming recession. Some investors believe the Fed will be forced to keep interest rates on hold next year. Even a near-certain increase later this month is now in doubt. Yet the fact that a more dovish tone from the Fed itself in recent weeks failed to lift sentiment suggests America’s central bank is not to blame.

The other oft-cited reason for the turbulence is mounting scepticism about the trade ceasefire. The S&P 500 fell nearly 3 per cent last Thursday morning following reports that the chief financial officer of Huawei had been arrested, showing the extent to which markets question the durability of the truce and remain sensitive to tensions between the US and China.

Yet the trade war has been weighing on sentiment for several months now. While the ceasefire is fragile, both sides have at least agreed to resume talks. It is hard to understand how such an outcome (the best markets could have hoped for, given the perilous state of relations between the world’s two-largest economies) could be the catalyst for a further 4.5 per cent decline in the S&P 500 since November 30, the day before the cooling-off period was agreed.

Forget the ‘truce’, the Trump-Xi rivalry is just getting started

There is a more compelling explanation for the turmoil. At the core of investors’ fears about the Fed and the trade war are worries about global growth which, as I argued in my previous column, have become more pronounced over the past two months.

While markets have begun fretting about the health of the US economy, the nation remains on track to achieve its longest-running expansion despite the Fed’s significant withdrawal of monetary stimulus. The woes of China’s economy, by contrast, run much deeper, for reasons which mostly predate the escalation of the trade war. What is more, the spillover effects have been more damaging to sentiment due to China’s growing economic and financial clout, with the country now accounting for 15 per cent of global gross domestic product (compared with 3 per cent during the Asian financial crisis) and 31 per cent of the benchmark MSCI Emerging Markets equity index.

Why deleveraging is the wrong way to fix China’s economy

Although it is difficult to disentangle the myriad factors responsible for each bout of turbulence this year, China has been the most important exporter of volatility from a cross-asset perspective. An MSCI index of stocks in advanced economies that are most exposed to China has performed significantly worse than the broader developed market index over the past year. Industrial metals prices are on the cusp of a bear market, down nearly 20 per cent since early June, according to a Bloomberg index, mainly because of fears about the slowdown in China, the world’s largest consumer of raw materials.

In emerging markets, Asian equities have performed significantly worse than other regions this year, particularly in the past three months. More tellingly, emerging market currencies fell sharply between April and August, the period when the yuan was sliding against the US dollar. Yet, since China’s currency stabilised towards the end of October, emerging market currencies have rebounded even though the US dollar continued to strengthen.

While China’s role in the last major global sell-off three years ago was more clear-cut due to the fallout from the surprise devaluation of its currency in August 2015, Beijing’s more aggressive stimulus measures at the time helped calm markets. This time round, however, the policy response has been inadequate and confused, due to the constraints imposed by the deleveraging campaign.

As concerns about global growth intensify in the coming months, China’s importance as a driver of market volatility will increase further, particularly if (as seems likely) trade tensions flare up again. The last time China’s manufacturing sector began to contract, in September 2015, global markets suffered sharp losses. Last month, the nation’s manufacturing output was dangerously close to contraction territory. China-induced turbulence in markets is likely to persist for some time yet.

Nicholas Spiro is a partner at Lauressa Advisory