Indeed, at one stage, the Dow Jones Industrial Average found itself down more than 500 points, its steepest fall since the Invasion of Iraq in March 2003.
The trigger for Shanghai’s correction was a report that the authorities were planning a crackdown on “speculative activity” – essentially preventing retail investors from re-mortgaging their properties and investing the proceeds in a seemingly upwards only equity market. However, given that this, by definition, has been an entirely domestic phenomenon, it is difficult to see why such developments should have such far reaching implications for equity markets elsewhere. True, China’s importance as an economic power has increased hugely in recent years, but the link between developments in its equity market and those in the rest of the world is less clear cut.
The question all rational investors should be asking is what, if anything, has now changed as a result of yesterday’s excitement? If the correction in Shanghai was likely to result in a sudden deceleration in economic growth in China then perhaps there would be cause for concern. But this is highly unlikely; even after yesterday’s falls the main benchmark index was still 7.7% up on its start year level and a massive 121.8% higher in year-on-year terms. Regardless of what happened yesterday, our best estimate remains that the Chinese economy will continue to expand by around 9-10% a year for the foreseeable future. Consequently, Chinese demand for commodities and for goods and services produced by the rest of the world will remain strong.
Could it be that yesterday’s correction simply turned the spotlight onto what were increasingly expensive global equity markets? With the notable exception of the UK – where we have observed previously that equities were no longer “obviously cheap” – this simply doesn’t tally with the data. Admittedly, we are now four years into the bull market in equities (or as some commentators would have us believe a bull phase within a secular bear market), but with corporate earnings continuing to surprise on the upside, valuations in most major markets have remained low, even after the recent spike up in bond yields.
A bigger concern would be the US economy sliding into recession later in the year – a possibility highlighted yesterday by former Fed Chairman Alan Greenspan. Indeed, under such circumstances, we would expect to see corporate earnings declining in absolute terms. However, we just can’t see this happening. A deceleration in the pace of US consumer demand growth has long since been a key feature of our economic forecasts, but an outright decline in personal consumption (which is what recession in the US would imply) is extremely unlikely. True, the housing market is under pressure, but the balance sheet effects of modest price falls need to be set in the context of huge gains over the last few years and rising asset values elsewhere. As a result, we continue to expect the US economy will experience a soft landing this year, with the risks to our growth forecasts remaining to the upside.
We are therefore largely unfazed by the events of yesterday. Prior to yesterday’s sell-off most valuations were undemanding – they are even more so now. And with economic fundamentals still generally supportive – albeit less so than in the last couple of years – we continue to expect further gains from equities in the year ahead.